A second, complementary, approach for containing or cushioning fluctuations in the credit cycle would be to rethink the design of contracts – if you like, lowering the alcohol content of debt instruments. Some debt contracts are ill-suited to the needs of their customers, with the debt servicing burden rising at just the point borrowers are least able to pay. For example, the “teaser rate” mortgages offered to households in the US generated an automatic and correlated spike in income gearing as rates were reset. This amplified repayment and default risk. A better-designed debt contract would automatically adjust repayment terms when the borrower found the going getting tough. Debt would become, in the language of economics, state-contingent – contingent on the borrower’s state of financial health. By cushioning fluctuations, these instruments have the potential to stabilise automatically debt dynamics. And by averting costly default, they potentially benefit both creditors and debtors. There has been recent interest among banks in issuing state-contingent instruments – socalled contingent capital. These instruments convert into equity in the event of a pre-defined stress trigger being breached. So these instruments offer repayment insurance to banks at the point it is most valued. They are, in effect, a contractually pre-committed form of debtequity swap. The design of contingent capital needs further consideration – for example, the definition and calibration of the trigger thresholds. Nonetheless, experience to date offers encouragement. The contingent capital instruments issued at the end of last year by Lloyds Banking Group have risen in price since being issued.
A normalisation of long-term interest rates would increase UK companies’ debt servicing costs from 17% of profits currently to around 33%. 6  Reinhart, C M and K Rogoff (2009), This Time is Different – Eight Centuries of Financial Folly, Princeton University Press. 7  Data are not available for all ten countries, so period averages are based on slightly different samples. 8  Bank of England Financial Stability Report, December 2009. 4  BIS Review 10/2010  That is significantly below the levels reached in the early 1990s, when debt servicing peaked at 58% of profits. But the distribution of debt across companies again paints a less promising picture. In 2007, around 25% of UK firms made insufficient profits to cover their interest payments (Chart 11). This is a long tail. For sovereigns, debt servicing costs among the G7 economies are currently low, at around 3% of GDP. But were medium-term interest rates to normalise, against a backdrop of rising debt ratios, the combined effect would be significant. Over the medium term, debt servicing relative to GDP in the G7 economies would double. Finally, banks’ refinancing burden in the next few years has grown as a result of a shortening of debt maturities during the crisis. The average maturity of US banks’ rated debt is estimated by Moody’s to have fallen from 6.7 years to 3.2 years since 2005. Among UK banks, it has fallen from 6.8 years to 4.3 years.