Andrew G Haldane: Capital discipline Remarks by Mr Andrew G Haldane, Executive Director of the Bank of England, based on a speech given at the American Economic Association, Denver, Colorado, 9 January 2011. *  *  *  The views are not necessarily those of the Bank of England or the interim Financial Policy Committee. I would like to thank Tamiko Bayliss, Paul Bedford, Samuel Knott, Priya Kothari, Salina Ladha, Vasileios Madouros, Clare Rogowski, Victoria Saporta, Rhiannon Sowerbutts, Marco Spaltro, George Speight, Belinda Tracey, Paul Tucker, Matthew Willison and Peter Zimmerman for comments and contributions. The Basel Committee sets capital standards for international banks. There are now three vintages of these standards: so-called Basel I dating from 1988, Basel II dating from around 2004 and Basel III which was agreed at the end of last year.1 These international capital standards are supported by three pillars. Pillar I defines the regulatory rules, Pillar II provides scope for supervisory discretion, while Pillar III seeks to foster market discipline through disclosure. In countering systemic shocks, three supporting pillars have understandably been felt to be better than one. But the success of international capital standards in forestalling banking distress has been mixed. Basel I regulatory rules were arbitraged due to their risk insensitivity. This gave rise to Basel II with its greater focus on risk calibration. But Basel II buckled under the weight of the recent crisis. Repairs have since been applied through Basel III. Historical experience suggests this is unlikely to be the end of road.

Market measures provide both fewer false positives and more reliable advance warnings of future banking distress. Taken together, then, market-based solvency metrics perform creditably against first principles: they appear to offer the potential for simple, timely and robust control of a complex financial web. Contractual prompt corrective action But how should these market-based metrics be put to use in the design of a regulatory framework? Market warnings are useless unless they are acted on, either by the market itself or by regulators. It is not too difficult to devise a reconfiguration of banks’ capital structure that would bake-in the benefits of simplicity, robustness and timeliness. This would involve a cocktail of revised regulatory capital standards fortified by market discipline. It might work as follows. Alongside equity, banks would be required to issue a set of contingent convertible instruments – so-called “CoCos”. These instruments have attracted quite a bit of attention recently among academics, policymakers and bankers, though there remains uncertainty about their design.12 In particular, consider CoCos with the following possible design characteristics.   Triggers are based on market-based measures of solvency, as in Charts 6–8.   These triggers are graduated, stretching up banks’ capital structure.13    On triggering, these claims convert from debt into equity. Although novel in some respects, CoCos with these characteristics would be simple to understand. They would be easy to monitor in real time by regulators and investors. And they would alter potentially quite radically incentives, and thus market dynamics, ahead of banking stress becoming too acute.