Agency costs and moral hazard under the new banks' capital regulation : diagnosis, modelling and solutions

Martín Cerón, Jorge (2017) Agency costs and moral hazard under the new banks' capital regulation : diagnosis, modelling and solutions. Doctoral thesis, Birkbeck, University of London.

Abstract

This thesis investigates the agency costs and moral hazard associated with the new capital regulation for banks in the event of balance-sheet losses. The recent introduction of "Bail-in" provisions, under which unsecured creditors must contribute to banks’ rescue through recapitalisation, and the regulatory stipulation of higher equity requirements, will have profound effects on the traditional agency relationships between shareholders and bondholders of banks. These Bail-in provisions imply, "Deviations from the Absolute Priority Rule" (DAPR). This dissertation undertakes quantitative and qualitative analyses of the new Bail-In structures, focusing on their microeconomic consequences that lead to perverse incentives of the equityholders and subsequently propose practical solutions to the identified problems. The first main result reveals that Bail-in could actually aggravate the agency costs by intensifying the "wealth transfer" from bondholders to equityholders. The second main result is to demonstrate that enforcing higher monitoring costs to the bondholders reduces equityholders’ incentive for moral hazard via higher cost of capital. The use of financial and non-financial covenants within the "Bail-In-Able Debt" indenture has been proposed as practical solutions to facilitate bondholders’ monitoring efforts. However, close to the Point of Non-Viability covenants are no longer effective as the risk of DAPR looms, and the equityholders are tempted to attempt "gamble-for-resurrection". To attenuate this distortion of shareholder incentives, Bail-in provision must impose some cost on shareholders. They could be made to face significant dilution, through a fair debt-to-equity swap with bondholders at market prices, or face full dilution via private expropriation by a new shareholder base that we term "Contingent Equity Base". This is the third main result. Overall, this dissertation makes a significant step forward into the understanding of the microeconomic consequences of the new bank’s capital regulation in general and the Contingent Convertibles in particular whilst offering practical solutions to the problems.

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