In an op-ed for the New York Times, Harvard professor N. Gregory Mankiw wrote:
“My favorite proposal is to require banks, and perhaps a broad class of financial institutions, to sell contingent debt that can be converted to equity when a regulator deems that these institutions have insufficient capital. This debt would be a form of preplanned recapitalization in the event of a financial crisis, and the infusion of capital would be with private, rather than taxpayer, funds. Think of it as crisis insurance.”
I decided to take the time to comment it because that is a very good example of what I call ‘cute ideas’. Those are theoretically sound but shallow policy arguments that make their proponent look smart, generate a certain good feeling on the readers and listeners that ‘get it’, yet are not more than hot air upon further inspection.
Modern banks (the point is valid for other financial institutions too) finance themselves through a wide array of liabilities: insured deposits by the public, long-term bonds, stock issuance, repos and other short-term debt instruments. What we learned from the recent crisis is that short-term debt by banks is systemically risky. If for some reason, justified or not, there is an increase in the perceived riskiness of short-term debt, banks are not capable of rolling over their liabilities and the financial system may collapse.
The proposal by Professor Mankiw is to require banks to issue short-term debt that is convertible into equity. If a well-informed regulator deems the capital levels of those institutions inadequate, by a stroke of bureaucratic magic, they are converted into equity and capital levels are adequate again.
But the question is: would the current providers of short-term wholesale finance be willing to keep providing it once those instruments can be converted into equity by bureaucratic fiat? Certainly not or else they would be buying other instruments such as long-term loans or bank stocks that provide in general a higher yield. Hence Mankiw’s proposal would at the very least cause an increase in the wholesale financing cost of banks – which for those of us who are worried about too much risk taking by banks is a good thing.
But now about the cuteness: why would this measure be superior to just taxing short-term wholesale liabilities of systemic banks as the Obama administration has already done? I can't see why or how.
Oh yeah... Mankiw's proposal is cuter!!
I look forward to hearing dissenting arguments on this one.