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A New Capital Regulation For Large Financial Institutions

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  • Hart, Oliver
  • Zingales, Luigi

Abstract

We design a new, implementable capital requirement for large financial institutions (LFIs) that are too big to fail. Our mechanism mimics the operation of margin accounts. To ensure that LFIs do not default on either their deposits or their derivative contracts, we require that they maintain a capital cushion sufficiently great that their own credit default swap price stays below a threshold level. If this level is violated the LFI regulator forces the LFI to issue equity until the CDS price moves back below the threshold. If this does not happen within a predetermined period of time, the regulator intervenes. We show that this mechanism ensures that LFIs are solvent with probability one, while preserving the disciplinary effects of debt.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7298.

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Date of creation: Jun 2009
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Handle: RePEc:cpr:ceprdp:7298

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Keywords: banks; Capital requirement; too big to fail;

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  1. Scott, Hal S. (ed.), 2005. "Capital Adequacy beyond Basel: Banking, Securities, and Insurance," OUP Catalogue, Oxford University Press, number 9780195169713, October.
  2. John B. Taylor & John C. Williams, 2008. "A black swan in the money market," Working Paper Series 2008-04, Federal Reserve Bank of San Francisco.
  3. Myers, Stewart C. & Majluf, Nicolás S., 1945-, 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Working papers 1523-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  4. Douglas D. Evanoff & Larry D. Wall, 2000. "Subordinated debt and bank capital reform," Working Paper Series WP-00-7, Federal Reserve Bank of Chicago.
  5. Philip Bond & Itay Goldstein & Edward Simpson Prescott, 2010. "Market-Based Corrective Actions," Review of Financial Studies, Society for Financial Studies, vol. 23(2), pages 781-820, February.
  6. Hull, John & Predescu, Mirela & White, Alan, 2004. "The relationship between credit default swap spreads, bond yields, and credit rating announcements," Journal of Banking & Finance, Elsevier, vol. 28(11), pages 2789-2811, November.
  7. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  8. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
  9. Stewart C. Myers & Nicholas S. Majluf, 1984. "Corporate Financing and Investment Decisions When Firms Have InformationThat Investors Do Not Have," NBER Working Papers 1396, National Bureau of Economic Research, Inc.
  10. Myers, Stewart C. & Majluf, Nicholas S., 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Journal of Financial Economics, Elsevier, vol. 13(2), pages 187-221, June.
  11. Kashyap, Anil K. & Rajan, Raghuram G. & Stein, Jeremy C., 2008. "Rethinking capital regulation," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 431-471.
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