The Winter issue of National Affairs is out, and one of the highlights is an article by a professor at Columbia Business School, Charles Calomiris, that runs under the headline "How To Regulate Bank Capital":
All companies need to maintain adequate capital to help them survive financial distress, so why do banks — unlike other firms — have formal capital requirements imposed by government regulators? For most companies, the market is the regulator that encourages them to maintain adequate capital: Firms that choose too low a capital ratio will pay higher interest on their debts, as the holders of those debts judge them to be riskier investments because their capital might prove inadequate in a time of financial difficulty. This used to be true of banks as well, but has not been since at least the middle of the 20th century, thanks in part to several government policies implemented in response to the Great Depression. As a consequence of government deposit insurance (like that provided in the United States by the Federal Deposit Insurance Corporation) and other government policies that protect debt holders from losses, bank-debt holders in most countries today typically do not bear losses when the banks they have invested in (or deposited in) fail. That removes the incentive for debt holders to charge higher interest rates for the higher default risk assumed when banks maintain inadequate capital. The assumption that large banks in particular will be bailed out by their governments if they approach failure — an assumption confirmed by prominent rescues over the past few decades, and of course by more recent events — has further reduced the market's incentive to discipline banks through higher interest rates.
Professor Calomiris recommends a five-year transition period to a new capital requirement of 20% of risk-weighted bank assets, with 10% of the capital in equity and 10% in contingent convertibles. Professor Calomiris's "CoCo's" are somewhat similar to Canadian bank regulator Julie Dixon's proposal for "embedded contingent capital," which was covered here back in 2010.