Third, sufficient level of contingent capital should enable a well-run bank to still operate with significant leverage and thus earn a healthy return. In the more extreme suggestions for the amount of contingent capital, one would very substantially change the return profile of common equity for banks, perhaps creating an entirely new investor category. There are two lessons from this paper which should be applied to contingent capital instruments. First it has been suggested to us by market contacts that the trigger point in existing contingent instruments is such that many investors have bought them on the assumption that these contingent capital securities never will be called (or worse, that there will be official support before that point). If that were to be the foundation for this market, we believe that the very purpose of contingent capital may be subverted, creating a risk to financial stability in a crisis situation. The whole point of contingent capital securities should be that the recapitalisation is triggered without any grand repercussions, making it easier than raising fresh capital in the market. If triggering the conversion were to cause the sort of damage reported in our examples above, then the market could be severely disrupted just when it was most needed. The contract design must therefore reflect a need for the trigger to be as smooth as possible. One potential mitigant would be to have a range of trigger levels, so no single level becomes a focal point for indicating severe distress.
In a very interconnected financial system, it can be almost self-fulfilling that when the market starts to think some of the banks are in trouble, in fact all of them are4. A third example in this section is the dynamic hedging strategy of a bank’s credit risk arising from its derivatives portfolio (Credit/Counterparty Valuation Adjustment: CVA hedging). This normally refers to the credit risk of a counterparty that is not directly offset by some form of collateral5. Suppose a corporate has issued a fixed rate bond because investor preference makes that the best value, but really it wants to have a floating rate liability. A bank will accommodate this by providing an interest rate swap. If interest rates go up, that swap may generate a net value owing to the bank. Receiving that value depends on the corporate not defaulting and so the bank will have a credit exposure to the corporate. But the corporate cannot be expected to post collateral – it will just regard its debt as having been converted to floating rate (and typically it won’t hold any collateral it could post anyway). A bank that is active in these interest rate swaps will end up with a large number of such mark-to-market exposures. Collectively, the resulting exposures constitute a credit portfolio which changes with the mark-to-market values of the underlying derivatives contracts. To manage the credit risks embedded in this so-called CVA portfolio, most banks will hedge dynamically in the CDS market.