Contingent capital An ideal capital requirement regime should be efficient and should create the proper incentives for banking organizations to internalize the costs of their actions on the broader financial system and macroeconomy. Efficiency, which I’ll define here as minimizing the amount and cost of capital needed to ensure solvency under adverse conditions, is important because an inefficient system will inevitably encourage growth in activity outside the regulatory regime, and will likely drive up the overall cost of intermediation. Proper incentives are needed to control risk and better align the interests of management and shareholders with those of the public. In both respects, the introduction of a contingent capital instrument seems likely to hold real promise. Relative to simply raising capital requirements, contingent capital has the potential to be more efficient because the capital arrives as equity only in the bad states of the world when it is needed. It also has the benefit of improving incentives by creating two-way risk for bank managements and shareholders. If the bank encounters difficulties, triggering conversion, shareholders would be automatically and immediately diluted. This would create strong incentives for bank managements to manage not only for good outcomes on the upside of the boom, but also against bad outcomes on the downside. Conceptually, contingent capital instruments would be debt instruments in “good” states of the world, but would convert into common equity at pre-specified trigger levels in “bad” states of the world.
Iceland’s sovereign credit rating soared during the years before the crisis, and Icelandic banks’ credit ratings followed in its wake. In fact, perhaps they rose higher than was warranted and was good for us. In spite of the ensuing nosedive, we managed to keep the sovereign rating on the bottom rung of investment grade, apart from two years in Fitch Ratings’ speculative category after the first Icesave referendum. Keeping Iceland’s ratings in the investment-grade category cost an incredible amount of effort, and other countries that have gone on an IMF programme in recent years have seen their ratings from Moody’s and S&P fall to speculative grade. Some of them have managed to rise up faster than Iceland has, however. Studying the rating agencies’ reports shows which factors will be most important in order to improve Iceland’s sovereign rating and thereby pave the way for the banks to follow suit. Among them are continued reduction of public debt levels and sound, focused economic policy that provides stability throughout the ongoing upswing. The liberalisation of the capital controls is an extremely important factor, but it could work both ways. Successful moves towards liberalisation without jeopardising stability will have a positive effect, but disturbance of economic and financial stability will do the opposite. My assessment of this, and of conversations with the rating agencies, is that it is probably not realistic to expect an improvement in our sovereign rating in the very near term.