In his Senate Banking testimony yesterday, Acting Comptroller John Walsh states that the FSOC has accelerated one of the decisions mandated by Dodd-Frank: whether or not systemic firms should be subject to a contingent capital (often called a coco) requirement. Although the law doesn’t require more than a study here and, then only one due in mid-2012, FSOC has turned up the heat because global regulators have now decided that big banks must hold “bail-in debt.” This is coco au lait – that is, a sort-of contingent-capital requirement. As we’ve noted before, bail-in debt is premised on bail-out public policy – the opposite of the direction Dodd-Frank demanded. Straight coco, in contrast, is designed to add an early-warning capital trigger that promotes market discipline without creating any expectations of subsequent government intervention.
With the Basel bail-in debt decision done, the U.S. must come up with its own policy to avoid either an accidental asymmetry that puts U.S. banks at undue disadvantage or, even worse, imposition of a punitive capital charge with, at least in our view, adverse policy and market impact. It’s for this reason that the FSOC has put its foot on the pedal. Although Congress gave it time, Basel hasn’t.
The final Basel bail-in debt requirements apply to any nation that doesn’t have a statutory resolution regime. Even if a nation does have law here, the details of the Basel rules make clear that this isn’t good enough. Although nations with a resolution regime need not adhere to the strict letter of the Basel rules, their bail-in debt must still meet express requirements that are in large part premised on public intervention that rescues failing banks. This is, of course, in sharp contrast to Dodd-Frank, the U.S. statutory-resolution regime designed to bar bail-out.
U.S. regulators didn’t get the “out” from bail-in debt requirements for which several (albeit not all) were hoping. They must now try to band together and then to figure out
what coco and/or bail-in debt mean here and whether the U.S. will try to meet the Basel III criteria or just impose a contingent-capital requirement – or not – that meets U.S. statutory, policy and market criteria.
As this debate begins, EU banks are already experimenting with coco. Credit Suisse brought an issue to market last week and Barclays is reportedly considering doing the same. Or, sort of the same. Interestingly, the Barclays issue may be a substitute for bonuses – that is, it would be equity issued to insiders that turns into cash only if the bank prospers. This would be a different form of coco – in which equity interests would vest if a bank doesn’t fail versus the traditional supervisory view of coco. Under that, equity interests are “triggered” in a supervisory event and investors then lose all ahead of the other creditors, which pick up the pieces of whatever remains.
Where does this leave FSOC? In one sense, with an open field. EU market developments are wholly inconclusive and there is to date no inkling of any comparable issues in the U.S. However, the Basel III bail-in debt standards constrain the U.S.’s free hand.
Thus, FSOC faces three choices: buckle under to Basel III’s bail-in debt rules, mandate our own form of coco or skip contingent capital and give U.S. banks a chance to deal with all the other requirements now beleaguering them in the midst of a still-uncertain economic recovery.
As the foregoing suggests, we oppose the first course. We think the Basel bail-in debt standard is dubious in its own context and backward-looking in the U.S. one in the wake of Dodd-Frank’s systemic-resolution requirements. Over time, true coco could well compliment other capital requirements. It’s thus a good concept on which more work needs to be done. This FSOC now has in hand
But, even if FSOC gives coco a clear go-ahead, it should proceed with caution. All of the recent capital, liquidity and prudential standards have yet to be implemented, let alone tested. Too many moving regulatory parts can wreck the still-fragile global financial machinery. Adding this one atop all the others too early poses new risks no one now need run.

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