Over the weekend, the Economist featured an article reviewing research written by, Jeremy Bulow and Paul Klemperer, economists from Stanford and Oxford University respectively. The research paper titled “Equity Recourse Notes: Creating Counter-cyclical Bank Capital” provided an alternative debt instrument for banks to use when raising capital.
Called Equity Recourse Notes (ERNs), the product is a hybrid debt issue that converts into equity upon a bank’s stock price falling below a specific price. According to Bulow and Klemperer, the need for ERNs comes in response to the increase of hybrid products being issued since the global financial crisis (GFC) revealed how leveraged and vulnerable banks were to even small decreases in their capital.
Among the leading hybrid products in the aftermath of the GFC have been contingent convertibles (CoCos). Issued for the first time in 2009, these securities convert into equity based on regulatory events, such as a firm’s debt capital failing to meet minimum requirements. The benefit for stakeholders is that in the event of troubles at a bank, debt gets converted to equity which reduces the firm’s creditors and potential insolvency.
Regulators are reluctant to actively force a recapitalization
However, according to Bulow and Klemperer, CoCos provide a risk in that conversions take place at once and can flood new equity in the market. They added that attaching the contingency event to regulators, there is a risk that regulators may delay announcing that an institution is undercapitalized if it could trigger an equity conversion, stating “Regulators are reluctant to actively force a recapitalization because doing so will send a negative signal about the bank’s current financial status, possibly exacerbating a bad situation.”
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Providing an alternative, Bulow and Klemperer’s ERNs tie their conversion to stock prices. As an example, an ERN that was issued when a stock is at $80 and requires prices to fall below 25% of the current level, wouldn’t convert to equity unless shares dropped below $20. In addition, only current payments would be converted. Therefore, if the stock would subsequently trade back above $20, the bank would no longer cover debt payments in equity, but would pay in cash.
Bulow and Klemperer also theorized that a company would issue ERNs at multiple different price points. As a result, even in the case of a bank’s price collapsing, equity conversions would take place at different price points.
Due to the benefits versus CoCos, Bulow and Klemperer believe that one of the key advantages of ERNs is that using them will ultimately lead to more stable financial systems. The belief is based on their theory that by using ERNs, banks will be less hesitant to raise debt during difficult economic periods. The result would be continuous lending to customers as a bank would be less likely to curb its debt and would continue to raise capital even as its stock is falling.