People across the globe are coming with an idea of hybrid debt securities that will be converted in to equity capital of bank if the share price of the bank falls below a trigger level or the capital base falls below the regulatory level as it normally happens in the time of crises due to heavy loss. The idea is good because the crisis becomes severe due to erosion in the capital base of banks as it disrupts the whole financial intermediation process and shakes the faith in financial system which makes recovery tougher. Due to our experience from banking failures in this crisis and previous crises we know that banks find it very difficult to raise the capital in time of crisis as it is required to fulfill the regulatory requirement of minimum capital and that is the main reason of banking failures so if we can make arrangement of capital well in advance that will reduce banking failures and might reduce the severity of crisis and that is the logic behind the proposal. But there are some problem associated with it. Existing shareholders of the bank might take it as loss cushion and may take excessive risks because now there will be less chances of failure and so instead of reducing moral hazard it will increase moral hazard. Secondly the regulator has to make it compulsory for all the banks since if it is being used by specific banks at the insistence of regulator then it will send wrong message about the involved banks in the market and market may penalize them and it might reach trigger level well before or there might be banks runs so it has to be made compulsory for all the banks and this will harm good banks because the contingent capital has to be issued at premium due to conversion clause in that and this will reduce the profitability of sound banks unnecessarily. Thirdly there might be some market manipulation by shorting shares of the bank and by investing in the contingent capital to bring the trigger level and reap the benefit when the contingent capital is converted in to shares. Deciding about the level of contingent capital will also be a problem and the regulator cannot change the requirement time often as it will bring unnecessary volatility in market due to share price movements and might create problem for the bank if requirement is raised. if So we can say that Contingent Capital is a good idea to reduce banking failure but without making the appropriate regulatory provision and understanding the consequences of it we must not implement this.
Federal Reserve is also analyzing this and it at is a tool being discussed at G-20 meetings.