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.

Banks were then asked to use their models to generate PDs and capital for this hypothetical portfolio, which could be compared across banks. The range of reported capital requirements held against this common portfolio was striking. For wholesale exposures to banks, capital requirements differed by a factor of over 100%. 6  Financial Services Authority (2010). BIS central bankers’ speeches  3  For corporate exposures, they differed by a factor of around 150%. And for sovereign exposures, they differed by a factor of up to 280%. Those differences could equate to a confidence interval around reported capital ratios of 2 percentage points or more. A final means of gauging potential model error is to consider past evidence. During the crisis, model error was largest and most egregious in the trading book. Charts 3 and 4 compare UK banks’ pre-crisis capital held against the trading book to trading book losses during the crisis. Losses were up to six times greater than pre-crisis trading book capital (Chart 3). And capital ratios would have needed to be up to 2.5 percentage points higher to accommodate this model risk (Chart 4). A fundamental review of the trading book is underway to address this problem. This evidence only provides a glimpse at the potential model error problem viewed from three different angles. Yet it suggests that model error-based confidence intervals around reported capital ratios might run to several percentage points. For a bank, that is the difference between life and death.