The Bank of England's financial stability chief has thrown his weight behind the development of a market for "contingent capital" as an alternative to breaking up financial firms that are deemed too big to fail.
Paul Tucker, the Bank's deputy governor for financial stability, said the idea could provide a form of "catastrophe insurance" for banks.
Contingent capital, also known as "CoCo bonds" automatically convert into equity to absorb losses when a bank gets into trouble.
Regulators could require contingent capital to be part of a bank's pre- written recovery plan, which would be triggered in a crisis akin to the market panic of last year. "If CoCos could form a material part of recovery plans, the landscape might just be transformed," he said.
Private-sector fund managers might be persuaded to sell such catastrophe insurance because the financial crisis triggered by bank failures would hurt the value of other assets in their portfolio, he said. In good times they would harvest interest on CoCo bonds, but if they had to covert them into equity at a loss, at least they would be helping the rest of their business.
The idea of requiring banks to hold contingent capital is moving up regulators' agenda on both sides of the Atlantic. Mervyn King, Governor of the Bank of England, said last month that the idea was "worth a try", though it might not solve the problem of excessive risk-taking.
Mr Tucker's speech on the nuts and bolts of financial reform came as details emerged of more sweeping promises from the Government to clean up banking in a Bill to be set out in the Queen's Speech tomorrow.
The set of government proposals, which includes new powers for regulators to rip up bankers' contracts if they lead to undesirable bonuses payments, is attracting widespread opposition in the City even before it is officially unveiled. The British Bankers' Association said it was now clear that the proposed legislation would "seriously disadvantage the UK economy".
"It is no surprise to find bankers' bonuses in proposed legislation but it needs to be remembered very few staff get the kinds of packages which capture the popular imagination," said Angela Knight, the BBA's chief executive. "We would be wary of actions which set the UK at a disadvantage, discourage international businesses from coming here and make it difficult to attract, reward and retain high-quality staff."
Paul Myners, the City minister, trailed the plan as a means of preventing excessive risk-taking by bonus-seeking bankers by allowing the Financial Services Authority to void contacts such as those which include multi-year guaranteed payouts. "We're not seeking to cap absolute levels of bonuses," he said. "We are going to make it clear that contracts which add bonus clauses that will add to risk, or contracts that will generate bonuses for risk-takers are no longer acceptable."
Sir George Mathewson, former chairman of Royal Bank of Scotland, told the BBC that the FSA already has enough tools to curb bad bonus systems. "Interfering with contracts that have been reached between willing participants is a somewhat dangerous route to go down."
But at least one law firm said the measures might be secretly welcome to banks. "It could ironically help protect firms from any possible breach of contract claims by affected employees," said Nicholas Stretch of CMS Cameron McKenna. "Some firms might even like the idea that they could get out of bonus payments by referring to regulatory obligations."
Other measures in the Queen's Speech include legislation allowing consumers to group together to launch class action lawsuits to claim damages from financial institutions that mislead customers over financial products. The FSA will also be given greater freedom to demand that banks pay compensation to groups of consumers.