William C. Dudley, President and Chief Executive Officer of the New York Fed, spoke yesterday at the Institute of International Bankers.  Dudley shared his views on how to strengthen the financial system.  He started by outlining what he sees as the basic cause of the crisis:

Regulators and market participants failed to fully appreciate the degree to which the various aspects of our financial system are interconnected, and to foresee what those tight linkages would mean for market function when even one reasonably large institution—let alone many—became distressed. We also did not fully appreciate the strength of the amplifying mechanisms that were built into our financial system; the consequence of which was to exacerbate the boom on the way up and worsen the bust on the way down. Contributing to these pro-cyclical dynamics were inadequate incentives for firms to curb their risk-taking and to more effectively manage the risks they did face. The inadequate level of transparency and disclosure, particularly in the market for structured products, were also important in making the financial system more fragile and vulnerable to crisis and in increasing the degree of uncertainty and contagion once the crisis was underway.

Dudley went on to outline a whole set of measures that might be taken to avoid the systemic risk that was central to the crisis.  Among the more interesting ideas he discussed was the notion of introducing contingent capital instruments.  These would be "debt instruments in “good” states of the world, but would convert into common equity at pre-specified trigger levels in “bad” states of the world," Dudley told the audience. 

Consider the advantages that such an instrument would have had during this crisis. Rather than banks clumsily evaluating whether to cut dividends, raise common equity and/or conduct exchanges of common equity for preferred shares and market participants uncertain about the willingness and ability of firms to complete such transactions and successfully raise new capital, contingent capital would have been converted automatically into common equity when market triggers were hit.

If these contingent capital buffers were large, which they could be because the cost of these instruments should not differ much from straight debt, then the worst aspects of the banking crisis might have been averted. If shareholders had faced the potential of automatic and substantial dilution, they may have demanded better risk management and disclosure during the boom. If common equity had been automatically bolstered during the early part of crisis, investors would have been much less concerned about the risk of insolvency. Counterparty risk concerns would have been much less significant—potentially short-circuiting one of the important amplifying mechanisms of the crisis. Such instruments could have reduced the likelihood of failure of large, systemically important institutions, reducing the significance of the “too big to fail” problem and its associated moral hazard problems.

Read the full speech here. 

(Hat tip to Mark Thoma for linking to the speech at Economists View).