How to Design a Contingent Convertible Debt Requirement That Helps Solve Our Too-Big-to-Fail Problem*

* This article is based on a paper originally published as “Why and How to Design a Contingent Convertible Debt Requirement,” Chapter 5 in Rocky Times: New Perspectives on Financial Stability, edited by Yasuyuki Fuchita, Richard J. Herring and Robert E. Litan, Washington: Brookings/NICMR Press, 2012. For helpful comments, the authors wish to thank, without implicating, Don Chew, Wilson Ervin, Mark Flannery, Charles Goodhart, Andrew Haldane, Tom Huertas, George Pennacchi, Kenneth Scott, Matthew Willison, and Peter Zimmerman. We are also grateful to the participants in the Brookings-Nomura-Wharton Conference on Financial Markets for comments on an earlier draft. 1. By “equity capital” we refer here and elsewhere in this article to the economic value of equity (which we later proxy with a moving average of the market value of equity) rather than the book value of equity. 2. See Coffee (2010) for the view that these apparent failures in corporate governance may in fact be the consequence of pressure from institutional shareholders for managers to take greater exposures to risk. To the extent that this view has merit, our proposal addresses it by creating substantial dilution risk for shareholders, including the CEO, who is also at risk of losing both his equity interest and his institution-specific human capital. 3. See Ellul and Yerramilli (2010). BA by Charles W. Calomiris, Columbia University, and Richard J. Herring, University of Pennsylvania