Charles Evans, the president and chief executive of the Federal Reserve Bank of Chicago, offered dramatic proposals Wednesday for how financial institutions should manage their capital, including forcing companies to buy capital insurance or issue debt that could be converted into equity in a crisis.
Each possibility has a downside, Evans said, but the idea is to send a message to the industry: A new era of regulation is dawning.
"It is important to create 'regime-shifting' reforms," he said in a speech to the European Economics and Financial Center in London. The changes would "announce to the industry that a new regulatory environment exists. … Realizing this, it would be in the financial firm's best interest to more prudently manage risk."
The Obama administration's proposal for regulatory reform would hand the Fed significant powers to manage capital requirements at holding companies. One way the Fed could do that is to require insurance that could be used if an institution's capital becomes depleted, Evans said.
"The purpose of the insurance is to address catastrophes," he said. "With this proposal, it is imperative that the insurance be fail-proof; thus, proposals typically require that the insurance funds be placed in a segregated lockbox — perhaps in Treasuries. Targeted issuers of the insurance could include sovereign wealth funds or private equity.
"The trigger for the insurance payment could be based on the conditions of the individual firm or on the condition of the financial industry."
An alternative would involve issuing debt that could be turned into equity if problems arise. Such a scenario would let a bank have capital on hand without unnecessarily diluting shareholders, Evans said.
"The triggering mechanism could be based on a number of things, including existing capital levels, equity share prices, declaration by the regulators that conditions of systemic stress exist or a violation of covenants in the debt contract," he said.
"Thus, the new debt instruments could improve risk-taking incentives and provide an additional capital cushion to insulate taxpayers and the deposit insurance fund from costly interventions," he added.
One of the biggest complaints from the industry about the regulatory response to the financial crisis is that institutions have been forced to raise capital in stressed periods when they are least able to do so. Evans said regulators could reduce such "pro-cyclicality."
"Just to fix ideas for the discussion, to be considered adequately capitalized," he said, "Tier 1 plus Tier 2 capital requirements could be changed from 8% across the entire business cycle, to perhaps 10% during 'good times' and 7% during 'problem times.' "
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