Some good ideas on future forms of financial regulation

I came across a good editoral in last weeks economist which suggested some new ideas for the future of financial regulation:

What form could such regulations take? First, instead of asking institutions to raise permanent capital, ask them to arrange for capital to be infused when they or the system is in trouble. Because these “contingent-capital” arrangements will be entered into in good times when the chances of a downturn seem remote, they will be cheap (compared with raising new capital in the midst of a recession) and thus easier to enforce. Because the infusion is seen as an unlikely possibility, firms cannot raise their risk profile, using the future capital as backing. And since it comes at bad times, when capital is scarce, it protects the system and the taxpayer.

One version of contingent capital is for banks to issue debt which would automatically convert to equity when both of two conditions are met: first, the system is in crisis, either based on an assessment by regulators or based on objective indicators; and second, the bank’s capital ratio falls below a certain value*. The first condition ensures that banks that do badly because of their idiosyncratic errors, rather than because the system is in trouble, don’t avoid the disciplinary effects of debt. The second condition rewards well-capitalised banks by allowing them to avoid the dilutive effect of the forced conversion (the number of shares the debt converts to will be set at a level so as to dilute the value of old equity substantially). It will also give banks that anticipate losses an incentive to raise new equity.

A collateral benefit is that, anticipating forced conversion, banks will raise new capital expeditiously when they make losses, thus protecting taxpayers. Of course, learning from the recent experience of foreign investors who put in money just before American banks declared more losses, new equity investors will need to be convinced that banks have disclosed fully all potential losses they know about.

Another version of contingent capital is the requirement that systemically important, and leveraged, financial firms buy fully collateralised insurance policies (from unleveraged firms, foreigners, or the government) that will capitalise these institutions when the system is in trouble**. Yet other versions would require banks to issue capital to top up losses based on public signal†.

I have not these ideas anywhere else (although I could have missed them) and at first glance, they seem to be pretty thorough.