Contingent Capital: A Tool of Restoring Market Discipline?

Abstract

Contingent capital is a new promising instrument that could provide banks with an expedited but potentially lower-cost private recapitalization mechanism in times of financial distress.  This paper aims to examine the potential role of contingent capital in restoring market discipline and as a countercyclical capital buffer.  A well designed contingent capital would help improve incentives for banks’ risk management and enhance market monitoring which thereby restoring market discipline in banking.  Moreover, the use of contingent capital to build up capital in good times when system-wide risks are growing markedly would help banks to absorb potential losses and prevent a credit crunch in the economy in bad times. Using Thailand’s experience over two different financial crises, namely the Thai financial crisis of 1997–1999 and the global financial crisis of 2007–2009, this paper provides empirical evidence supporting the use of a market-value capital ratio as a trigger for conversion of contingent capital, as well as the potential benefits of contingent capital as a countercyclical capital buffer to prevent future systemic crisis.  Although the room for contingent capital instruments to satisfy the Basel new capital requirements might be limited, this paper also supports the use of the instruments on top of the Basel requirements.