The Most Important Concepts in Finance
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The Most Important Concepts in Finance

Edited by Benton E. Gup

Anyone trying to understand finance has to contend with the evolving and dynamic nature of the topic. Changes in economic conditions, regulations, technology, competition, globalization, and other factors regularly impact the development of the field, but certain essential concepts remain key to a good understanding. This book provides insights about the most important concepts in finance.
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Chapter 15: Stabilizing large financial institutions with contingent capital certificates

Mark J. Flannery

Extract

Corporate limited liability makes firms’ shareholders under-value the possibility that their actions will have extremely bad outcomes. This distortion has been particularly relevant for banking firms because their equity capital ratios are low and the government has been willing to support weak banks in order to maintain financial stability. The subprime financial crisis clearly illustrates a strong official reluctance to let large financial firms fail. At the largest institutions, “too big to fail” (TBTF) conjectures insulate liability holders from a bank’s possible default. Shareholders are thereby encouraged to take greater risks and to operate with lower equity cushions. Asset mispricing may also distort real-sector allocations. In principle, Pillar 2 supervision should assure that large financial institutions maintain appropriate, risk-related capital standards on a continuing basis. However, real-world supervision is ill-suited to this task (Herring 2010; Bulow and Klemperer 2013; Flannery 2014a; Flannery and Giacomini (2015). “Adequate” capital is defined in terms of book accounting values, which provide managers with considerable flexibility about when to recognize some value impairments. Book equity values therefore tend to lag changes in a firm’s market value, particularly when a firm is encountering financial difficulties. Indeed, many of the most troubled firms in 2007–2009 were considered to be “well capitalized” according to Basel standards shortly before their names hit the headlines (Kuritzkes and Scott 2009; Duffie 2009; Haldane 2011). Coffee (2011) and section 2 of Bulow and Klemperer (2013) provide further discussion of the regulatory challenges associated with maintaining adequate bank capital.

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