Innovation Enhancing Dynamic Regulation via Contingent Capital

The issuance of contingent capital securities (CCS) is a promising dynamic regulatory mechanism that can help address the suboptimal regulatory outcomes associated with disruptive innovation.

Contingent capital is an automatic mechanism for increasing capital while reducing debt with the long-term benefit of lowering leverage. The conversion feature of contingent capital shows great promise to provide a mechanism for general risk control in financial institutions, and could enhance regulatory capital requirements by creating a regime for providing countercyclical regulatory capital. By internalizing bank failure costs, contingent capital may be able to minimize moral hazard, avoid financial contagion, and limit systemic risk. While most of the design features of CCS and their triggering events are underdeveloped, CCS could help regulators anticipate regulatory needs in real-time, supported by feedback effects and improved information for regulation.

The existing regulatory infrastructure contributes to suboptimal regulatory outcomes, especially when faced with ever-increasing disruptive innovation. Regulatory challenges presented by disruptive innovation are largely associated with (1) facts-based, ex-post, trial-and-error rulemaking with stable and presumptively optimal rules in the existing regulatory framework; (2) the timing of regulation; and (3) ever-increasing unknown future contingencies in rulemaking.

First, because facts-based, ex-post, trial-and-error rulemaking cannot anticipate regulatory issues created by innovation, rulemakers may not realize—or may realize much too late—what new regulatory demands apply to a given innovation and its associated regulatory issue.

Unlike the historic trend of linear evolution of technology, innovation, and associated regulatory developments, today’s innovation is exponential and society will encounter unprecedented change.  Rulemakers’ near-exclusive reliance on stable and presumptively optimal rules, created to attain permanent solutions for perceived regulatory issues, ignores the acceleration of change in the business  and financial environment and the necessity for rules driven by the exponential growth of technological innovation.

Further, the timing of regulation in an environment of exponential innovation is a significant problem for regulators. Formal rulemaking in the existing regulatory infrastructure is overly time-consuming, and the speed of product innovation often makes regulations pertaining to an innovative product obsolete before such regulations are finalized.

Finally, the existing regulatory infrastructure, with stable and presumptively optimal rules, is largely incapable of addressing the unknown future contingencies associated with disruptive innovation. Given the pace of innovation, future contingencies in rulemaking are likely to grow substantially, making the dynamic anticipation of future contingencies increasingly important for rulemaking.

Contingent capital is a dynamic regulatory mechanism because (1) capital injection is available only if and when needed; (2) signaling to regulators of impending regulatory issues via conversion of CCS to near worthless equity creates feedback effects; and (3) contingent capital may also incentivize management to lower their risk taking on behalf of the financial institution. Contingent capital accordingly exemplifies and supports the core tenets of dynamic regulation, which include improved information for rulemaking, feedback effects, and anticipatory regulation.

First, contingent capital has the potential to optimize information for rulemaking. CCS, when issued and triggered, produce highly valuable, real time, decentralized information on the financial wellbeing of a given regulated entity.

Second, contingent capital creates feedback effects because the conversion of debt into equity signals to regulators that the respective entity’s management was unable to avoid the trigger from debt to equity, which calls for increased regulatory scrutiny. In essence, the occurrence of the trigger from debt to equity creates real-time regulatory information that would require months or years to generate in a centralized system, and enables regulators to start a regulatory investigation if and when it is needed.

Finally, contingent capital enables anticipatory regulation because regulators may observe and react in real time to triggering events, before entities encounter financial calamity. Additionally, depending on the disclosure regime that pertains to the respective CCS, regulators will also be able to understand what financial disclosures can affect the stability of such CCS, which in turn may allow regulators to anticipatorily adjust their regulatory requirements and the intensity of regulatory investigations.

This post summarises my paper ‘Dynamic Regulation via Contingent Capital’.

Wulf A. Kaal is an Associate Professor at the University of St. Thomas School of Law (Minneapolis).