It appears that there is one common issue in bank resolution, recapitalization and structuring going concern capital instruments, the lack of a standardized, consistent, audited, comparable, transparent and well defined trigger. Market based triggers are subject to manipulation, regulatory triggers lack transparency and are hard to model, capital ratios are risk insensitive, remember Lehman? Early activation of trigger would be detrimental to shareholders as a bank may still have substantial going concern value; and late activation of trigger would be detrimental to creditors as the bank may have nothing of value left.
Traditional going concern audit reporting model provides only two risk insensitive solvency signals: going… going… going… gone. Going concern rating, on the other hand, measures the gradation of going concern risk over a pre-defined path to insolvency in a continuum: going… less going… much less going… gone. In rating going concern risk, equity-debt notching would be established based on relative allocation of cash flow between shareholders and creditors. As such, the equity-debt notching not only defines the notching differentials between going concern ratings and credit ratings, it also determines the relative allocation of going concern value between shareholders and creditors when the bank is approaching insolvency, or entering the zone of insolvency.
For example, when a going concern rating were higher than or on par with credit rating, that means the bank still had substantial going concern value and if resolution or CoCo bonds were triggered at this early stage, the shareholders would suffer great losses. On the other hand, if a credit rating were several notches higher than going concern rating, that means the bank would have almost depleted its asset value and creditors would suffer substantial losses if triggered at that late stage. In bank recapitalization situations, the same issue – relative allocation of going concern value between shareholders and creditors – would similarly emerge that would define the amount and structure of the recapitalization capital.
Going concern ratings and equity-debt notching can be effectively applied to quantitatively define triggers for bank resolution, recapitalization and going concern capital instruments. A trigger would look like this: going concern rating “BB” – credit rating “B-”, or simply “BB/B-”.
Comments and requests for follow up discussion are welcome.