Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Catastrophe bonds to recapitalize banking system

Anil Kashyap, Raghuram Rajan and Jeremy Stein presented a
fascinating paper at the Jackson Hole Symposium. This is my third post
related to this symposium and yes, finally, the papers are available
at the Kansas Fed website. The Buiter paper that I blogged about a few
days ago after reading it on the WSJ website is also now available at
the Kansas Fed website.

Kashyap, Rajan and Stein propose an instrument similar to a
catastrophe bond which would automatically recapitalize the banking
system when system wide losses cross a certain threshold. The starting
premise of their paper is that the high level of leverage in banks is
a rational response to governance problem of banks. If one accepts
this premise, then their proposal for contingent capital makes a lot
of sense. It gives banks capital to the banks when it is needed in the
crisis, but does not give it to them in the boom when they might
squander it.

It is a very clever idea, but I tend to be sceptical of the notion
that there is something special about banks that exempt them from the
Modigliani Miller arguments about capital structure. Rather I think
Friedman was right in his statement in a different context that banks
are not regulated because they are different, but banks are different
because they are regulated. After all, many non bank financial firms
run quite well with lower levels of leverage than banks, and the free
banking era was also characterized by relatively low levels of
leverage.

Kashyap, Rajan and Stein design their instrument very
elegantly to deal with moral hazard problems at the level of the
individual banks. My fear is that it will attract moral hazard on the
part of the regulators. In fact, I think that their bond is best seen
as non voting equity in a deposit insurance corporation. The
governance implications of this are a nightmare.

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