Updated at 3:17 p.m. on Nov. 16.

I do think that measures such as the Contingent Convertible Bonds would be a useful step. (I am pleased to agree with Charlie Calomiris on this one.) Some argue that it would be hard to know when to invoke the contingency clause. It strikes me that this argument largely vanishes when one realizes that the clause would of necessity be invoked by the time we got to the stage of a Bear Stearns or Lehman Brothers bankruptcy.

CoCos would not go very far in themselves toward comprehensive reform of the financial system, if that is the goal. But then no single policy measure would do that. I agree with Gillian Tett: “In theory, I think that CoCos certainly could be a useful additional to banks’ tool kits. However, in practice, the contagion risk suggests it would be dangerous to rely too heavily on an exclusive diet of CoCos for any policy ‘fix’.”

Two related issues are of much bigger import. First, is it a feasible goal to eliminate, credibly, the problem “too big to fail” or “too interconnected to fail,” ,thereby eliminating the critical moral hazard problem? My suspicion is that this is not an achievable goal, when push comes to shove, ex post, in a crisis; and if I am right, then it is very important that we don’t return to the rhetoric of claiming “no bank is automatically too big to fail” and so fail to regulate and collect insurance from the banks ex ante. This would just exacerbate the moral hazard problem. Commercial banks are like river banks in this respect.

Second, would the legislation that is offered by Senator Chris Dodd be a better approach to financial reform than alternative proposals, or even than the status quo? While the 1,000+ page Dodd bill undoubtedly has some good things in it (the CoCos and the principle of a Consumer Protection Agency in lending are probably at the top of the list), I believe it would be very damaging overall. The major reason is that it would seriously undermine the power of the Fed to set fully-informed monetary policy in normal times and to respond effectively in times of crisis. It seems that Barney Frank understands these things much better.

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There are no such silver bullets. How many Cocos should the regulators insist that Goldman Sachs, AIG, GE, Citigroup hold?

I have authored or coauthored numerous articles and a short book on the topic of the merits of requiring some form of subordinated debt as part of a bank's capital structure, which I strongly favor. CCCs are a special kind of sub debt, and probably the best kind to require that banks issue. Because they automatically convert into equity when the bank becomes troubled, there is no hope of avoiding "haircuts" by holders. That is important because it means that the yields on these bonds during normal times will reflect true market perceptions of the underlying risk of the institution (which is the main purpose served by sub debt, which acts as a canary in the coal mine for regulators by identifying relatively weak banks).

It is also true that having sub debt convert to equity provides a greater equity cushion during failure, but this is not as significant as its ex ante risk-revealing property (especially since the size of the CCC requirement is likely to be small).

The idea of requiring some form of sub debt, and CCCs in particular, has enjoyed widespread support among experts on financial reform for years. A mandatory sub debt requirement was advocated by all the Shadow Financial Regulatory Committees (the US, Europe, Japan , and Latin America ) about a decade ago (see the monograph by the US Shadow Financial Regulatory Committee, entitled "Reforming Bank Capital Regulation," 2000). The Gramm-Leach-Bliley Act of 1999 required that the Fed and the Treasury consider whether a sub debt requirement was a good idea. A Fed study at the time found evidence strongly in favor of its value as a signal of risk, but the Treasury and Fed (led by Messrs. Summers and Greenspan), decided not to require it, under pressure from the large banks who wished to avoid a new mandate. The Treasury's summer white paper proposed a CCC requirement, which has been recently advocated by several other prominent academics. The Pew Task Force on Financial Reform, in which I am a member, is about to issue a bipartisan consensus report on financial reform, which I believe will support a sub debt requirement in the form of CCCs.

If we are going to require CCCs, there are important design features that must be addressed (and which are addressed at length in the US Shadow Committee's monograph), including: restrictions on the armslength identities of holders (so that the signal is meaningful), and the requirement that offerings be floated fairly regularly in the market (to maximize information from pricing). It is also worth bearing in mind that the widespread use of CDS complicates a CCC issuance requirement. To be maximally effective, holders of the CCCs should not be able to lay off their risk, especially to the issuing bank

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