Equity Recourse Notes: Creating Counter-cyclical Bank Capital

We propose a new form of hybrid capital for banks, Equity Recourse Notes (ERNs), which ameliorate booms and bust by creating counter-cyclical incentives for banks to raise capital, and so encourage bank lending in bad times. They avoid the flaws of existing contingent convertible bonds (cocos)—in particular, they convert more credibly—so ERNs also help solve the too-big-to-fail problem: rather than forcing banks to increase equity, we should require the same or larger capital increase but permit it to be in the form of either equity or ERNs—this also gives some choice to those who claim (rightly or wrongly) that equity is more costly than debt. ERNs can be introduced within the current regulatory system, but also provide a way to reduce the existing system’s heavy reliance on measures of regulatory-capital.