In an op-ed written for Fortune, Kenneth Posner, author of the recently published Stalking the Black Swan: Research and Decision Making in a World of Extreme Volatility, provides a solution for stopping the next banking crisis.
In light of the recent financial reform bill passed in the U.S. congress and as G-20 representatives get ready to meet in Basel to discuss, among other things, how to prevent further financial crises, Posner puts forth a simple but effective idea:
require systemically important financial institutions (think Citigroup or Goldman Sachs) to issue so-called “contingent capital,” a kind of shock-absorber that would immediately kick in during a crisis to stabilize the institution and bolster its solvency.
Contingent capital could be a special kind of debt that automatically converts to common stock when the firm’s regulatory capital gets depleted. In the current political maelstrom, and despite all the self-congratulating on the much-needed financial regulatory reform package that was just passed by the Senate, this practical idea hasn’t gotten the attention it deserves.
As Posner explains, this type of “shock-absorber” would allow governments and markets to respond much quicker to stabilize firms and markets, and protect taxpayers from having to help bailout banks and financial institutions. Ultimately, such a policy will help the financial system as a whole grapple with “black swans” or unpredictable events. Posner concludes,
In normal times, issuing this special kind of debt should not be expensive. Firms that look systemically dangerous might face higher costs. To avoid these costs, risky firms could shrink their balance sheets or rethink their business models. In this way, the contingent capital requirement would brake the growth of large, risky financial firms, another goal of regulatory reform. And if we’re not truly preventing systemic failures with our reform plans, it’s worth asking whether they’re worth pursuing at all.