U.S. Treasury studies contingent capital solutions as pre-crisis bailout prevention tool

An initiative established under the Dodd-Frank Act by the U.S. Treasury to look at systemic risks and financial stability, the Financial Stability Oversight Council (FSOC), has just completed a study of contingent capital solutions to see if they are tools which could be leveraged to ward off financial crisis. The FSOC, which is charged with identifying threats to financial stability, promoting market discipline and responding to emerging financial market risks has published a report containing its findings.

Contingent capital facilities are used within the reinsurance and insurance sector as a way to provide a source of capital to raise new equity after catastrophic events impact. They have mostly been transacted as surplus note options or equity put options which allow rapid capital injections to be made into the re/insurance company after losses reach a certain level. We’ve covered a number of contingent capital facilities before.

The very name ‘contingent’ capital suggests that these arrangements provide capital contingent on a number of criteria being met. In some ways a catastrophe bond could be considered a contingent form of capital as certain trigger conditions have to be satisfied before a payment can be made to a sponsoring company. Because of the very nature of these arrangements, some have called them ‘just-in-time capital’ and now the U.S. Treasury has been assessing whether they could be used to pre-emptively protect financial institutions against requiring bail-outs or government funding.

As part of Dodd-Frank the FSOC had to submit a report to the U.S. Congress on the feasibility, benefits, costs and structure of a contingent capital requirement for nonbank financial companies and for large, interconnected bank holding companies. The report looks at types and structures of contingent capital instruments assessing the potential benefits from and drawbacks of the use of contingent capital. The aim of the report being to conclude whether contingent capital solutions could be used to enhance the safety and soundness of nonbank financial companies and interconnected bank holding companies.

In the conclusion the FSOC recommends that contingent capital solutions remain an area for continued private sector innovation and encourages the Federal Reserve and other regulators to continue to study the advantages and disadvantages of including contingent capital in their regulatory capital frameworks.

Interestingly the report looks at how you might trigger some type of contingent capital solution for financial firms and suggests a number of trigger mechanisms. These include macroeconomic or systemic triggers which would activate based on certain financial market conditions being met and firm specific being based on losses or specific accounting conditions. It’s interesting to consider whether such triggers could be used to structure some kind of contingent securities which could be sold to investors, in return for a coupon payment, and would payout based on similar conditions being met. Economic catastrophe bonds perhaps?

You can read the full report from the FSOC here.