Next Generation Financial Architecture. Part 1 - Convertible Capital Structure
- 2. Next Generation Financial Architecture Page 2 of 5 Introduction Debt plays a major role in human lives. Debt can help people survive, companies to outperform, countries to win wars. Failure to service debt can destroy families, companies, and sovereigns. Debt is a powerful weapon of self destruction of both lenders and borrowers. As such, it shall be at the center of the next generation financial architecture. Major religions such as Hinduism1 , Buddhism2 , Judaism3 , Christianity4 , and Islam5 recognize the dangers of debt and a rare consensus among them has been that lending for interest shall be prohibited. The proper way of lending money should be by taking a partner’s stake in the borrower’s business. This turns zero-sum game between lender and borrower into either win-win or lose- lose situation which eliminates a conflict of interests between the two parties. Recognizing that such idealized state may not be achievable (at least in the near term), it could be used as an inspiration and general direction for developing the next generation financial architecture. Objectives The main objective of the next generation financial architecture is to shift the balance from debt to equity markets through the standardization of capital structure of public corporations and the use of innovative financial instruments facilitating efficient management of this capital structure. The optimal capital structure should feature built-in, preemptive and corrective mechanisms for dealing with conflict of interests and credit defaults. Such mechanisms would trigger predefined course of actions for predetermined states of the world. Financial instruments facilitating this standard capital structure would be debt-equity hybrids eliminating or reducing the interest or changing its nature and contingent, convertible equity to achieve an orderly capital restructuring. 1 Vedic texts of Ancient India (2,000-1,400 BC) mention the “usurer” which is interpreted as any lender at interest. Hindu Sutra texts (700-100 BC). 2 Jatakas (600-400 BC) contain sentiments of contempt for interest were expressed. 3 Prophet Ezekiel equates interest to rape, adultery, murder, and robbery. (Ezekiel 18:8, 13). 4 Some verses from the Holy Bible prohibiting interest are, “Do not charge your brother interest, whether on money or food or anything else that may earn interest.” (Deuteronomy 23:19). 5 The criticism of interest in Islam was well established during the Prophet Mohammed's life and reinforced by several of his teachings in the Holy Quran dating back to around 600 AD.
- 3. Part 1 – Convertible Capital Structure Page 3 of 5 Financial Instruments Debt-equity hybrids incorporate the element of partnership between lender and borrower and change the nature of interest of traditional debt instruments. Two debt-equity hybrid instruments are of a particular importance for their bankruptcy-remote features. Two contingent equity instruments are essential for implementation of convertible capital structure. 1. Equity-coupon debt Debt obligation that pays coupon in a form of common stock eliminates the risk of default on coupon payments. This debt can be in a form of either bond or loan. A standard coupon size will help concentrate secondary market liquidity for any given maturity and will make the debt instruments more fungible across similar maturities. 2. Contingent Convertible Annuity Debt obligation that pays interest for the life of corporate entity and converts into preferred equity upon predefined daily price decrease of the common stock. This debt instrument would eliminate default on the final payment of principal. It would be different from preferred equity in that failure to pay interest on this debt instrument would constitute a credit event. Absence of the maturity date and the standard coupon of this annuity would concentrate secondary market liquidity in a single instrument allowing it to be used as a revolving line of credit. 3. Contingent Preferred Equity Equity ownership with limited voting rights in exchange for higher claim on assets and earning that converts into common equity upon predefined daily price decrease in the common stock. Limited voting rights as opposed to no voting right would compensate for convertibility. Together these features would reduce the free-rider phenomenon inherent in equity ownership. 4. Contingent Common equity Equity ownership with full voting rights that assumes losses implied from predefined daily stock price decrease as realized losses. Loss recognition takes place in a form of predefined, prorated reduction of number of common shares owned.
- 4. Next Generation Financial Architecture Page 4 of 5 Capital Structure Standard, unsecured capital structure as shown in Figure 1 would provide three means for preventing and containing systemic risk: • transparency and comparability across public corporations • predictability, expediency, and self-sufficiency in restructuring • continuity of normal business operations Figure 1. Standard, Contingent, Convertible Capital Structure Equity and Debt tranches should be all equal in size. This requirement would ensure a balanced capital structure able to withstand severe financial shocks. Public corporations should be encouraged to build up their capital structure from the bottom up sequentially through a tax mechanism imposed upon the notional principal amount of all tranches above any missing element. Automatic convertibility into lower tranche of the corporate capital structure triggered by medium and severe daily decreases of the common stock price would create a powerful mechanism of preemptive and corrective restructuring respectively. Additionally, either of these decreases would cause a change in the balance of power among equity holders and directly affect the board of directors and senior management. It would serve as a deterrent against conduct risk throughout the organization and discourage the asymmetry of information which inevitably results in sharp changes of stock price. Making Operational Liabilities senior to other unsecured debt is necessary for preserving normal business operations and preventing the spill over of one firm’s problems to the rest of the real economy. Employees Liabilities should be subordinated to those of clients and suppliers to ensure employees accountability and minimize moral hazard within the organization. Clients’ Liabilities Suppliers’ Liabilities Employees’ Liabilities Operational Liabilities Debt-Equity Hybrids Convertible Equity Equity-Coupon Debt Convertible Annuity Convertible Preferred Equity Common Equity
- 5. Part 1 – Convertible Capital Structure Page 5 of 5 Conclusions 1. Dominance of Debt markets over Equity markets is the main source of Systemic Risk. 2. Shifting the balance of power from Debt to Equity reduces Systemic Risk. 3. Standardization of capital structure of public corporations provides transparency and comparability across public corporations. 4. Convertibility of the standard capital structure of public corporations allows predictable, expedient restructuring without disruption of normal business operations.