I agree with prof. Mankiw on the requirement for contingent debt. By itself this new class of security might also serve as the crtically-required “canary in the coalmine”. We need to include in the required capital structure a security that is exquisitely sensitive to the market’s evaluation of the health and stability of the firm. I think that a layer of subordinated debt will be sufficiently sensitive – but it doesn’t incorporate an automatic increase in the firm’s equity. Would the contingent debt accomplish both objectives?
…[Greg Mankiw's] favorite proposal is to require banks, and perhaps a broad class of financial institutions, to sell contingent debt that can be converted to equity when a regulator deems that these institutions have insufficient capital. This debt would be a form of preplanned recapitalization in the event of a financial crisis, and the infusion of capital would be with private, rather than taxpayer, funds. Think of it as crisis insurance.
Bankers may balk at this proposal, because it would raise the cost of doing business. The buyers of these bonds would need to be compensated for providing this insurance.
But this contingent debt would also give bankers an incentive to limit risk by, say, reducing leverage. The safer these financial institutions are, the less likely the contingency would be triggered and the less they would need to pay for this debt.