Regulations Or Contractual Provisions To Control Systemic Risk?

Is the solution to 'too big to fail' financial institutions, more government regulations and supervision or Coasean contractual provisions for mandatory conversion of debt to equity and capital?

"When the government came in to rescue these large banks, it essentially made whole all of the debt of the banks, including the subordinated debt," [Wharton finance professor Marshall] Blume says. "That creates a problem for the future." In theory, creditors holding subordinated debt are paid only after senior debt holders get all they are owed. That extra risk makes subordinated debt holders more cautious in lending. Rescuing them encourages them to take unwise risks, according to Blume.

One potential remedy, he says, is to require that financial institutions that take on debt incorporate provisions to automatically convert it to shares of stock under certain crisis conditions. Removing debt and expanding equity would bolster balance sheets. And this approach would impose discipline, since stockholders generally suffer bigger losses than debt holders in a bankruptcy or other crisis. Moreover, stock holders have a say in corporate governance; debt holders do not.

"'Too Big to Fail': Can Regulation Control Systemic Risk?" Published: October 14, 2009 in Knowledge@Wharton.