that the risk margin is too high for its own purpose does not mean that when everything is added up, overall levels of resilience are themselves wrong. to be clear, though, the prudential regulation authority ( pra ) enters this review with no goal of either decreasing or increasing total capital in the sector. in fact at this stage we have not been presented with persuasive evidence that current levels are manifestly too high or too low. the sector has so far shown itself resilient to the financial consequences of the severe shock represented by the covid - 19 pandemic. but equally, the supply of insurance seems in the round to meet demand from the economy. moreover, we do not think about capital requirements in isolation, but as part of a three pillar regulatory regime ( comprising capital, risk management, and disclosure ). today i want to talk a little about how we think about capital adequacy within that broader framework, and specifically the interplay with strength of market discipline, the ladder of intervention, and the way that firms structure themselves. in the light of those factors, how do we judge when the level of capital is ‘ just right ’? the three pillar regulatory regime last year i talked about what the insurance sector does for the wider economy [ 3 ], which itself defines our mission in insurance supervision : the protection of policyholders and the stability of the supply of financial services to the wider economy. broadly speaking, those services are the pooling of risk, provision of secure retirement income, and long term investment. the safety and soundness of individual firms is a primary objective, but is not really an end in itself, it is a means to fulfilling our mission. we do not have zero appetite for failure of individual firms, provided that they do so in an orderly way that does not impose large costs or disruption on policyholders – neither in the form of direct losses nor of disruption – does not have knock on effects elsewhere in the financial system, and there is sufficient capacity elsewhere to substitute for the loss of the failing firm. we cannot leave this all to the market. intervention in the form of prudential regulation is necessary because of the inverted production cycle in insurance – policies pay out after, in many cases long after, they are taken out – because of the limited or non - existent ability of many policyholders to monitor or react to increases in risk taking by their insurer during the life of their policy, and because of the incentive for

firm. the firm faces a trade - off. debt confers the benefits of tax deductibility, while equity offers the benefits of lower expected bankruptcy costs. 15 the tradeoff between these two sets of benefits defines an optimal capital ratio for a firm to maximise its expected value ( chart 9 ). 16 now consider adding cocos to the mix. they are, in effect, a hybrid of debt and equity whose payoffs depend on the state of nature. when nature is kind and times are good, they offer the upswing ( tax - deductibility ) benefits of debt. and when nature is cruel and times are bad, they offer the downswing ( bankruptcy costs ) benefits of equity. they are, in the commission of experts for limiting the economic risks posed by large companies ( 2010 ). debt could also provide some incentive benefits in disciplining management ( jensen ( 1986 ) ). leland ( 1994 ). bis central bankers ’ speeches language of economists, a form of “ contingent ” contract when the contingency in question is crisis. as chart 10 illustrates, the optimal fraction of cocos in banks ’ optimal debt structure is likely to be non - zero. in other words, a cde capital structure might be a smart option for valuemaximising investors and managers, even without the need for regulatory intervention. the social value of such a capital structure might, of course, be greater still – for example, because the social costs of crisis are higher than the private costs. that would justify a regulatory capital backstop. this capital structure shares the risk - sharing benefits of some other reform proposals. for example, it has similar risk - shifting properties to a mutual fund or limited purpose banking model. 17 when required, risk is shared across the capital structure, as in a mutual fund whose equity claims adjust in value. but risk - spreading would only kick - in when it needs to. banks are banks when nature is kind and mutual funds when it is cruel. they can be butterflies in summer, provided they are hedgehogs in winter. from here to there if such a structure is for the best in most states of the world, why does it not already exist? at least two legitimate concerns have been raised. first, might market - based triggers invite speculative attack by short - sellers? the concern is that coco holders may be able to shortsell a bank ’ s equity to force conversion, then using the proceeds of a coco conversion to cover their short position