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Increased-Liability Equity: A Proposal to Improve Capital Regulation of Large Financial Institutions

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  • Admati, Anat R.

    (Stanford University)

  • Pfleiderer, Paul

    (Stanford University)

Abstract

While it is recognized that the high degree of leverage used by financial institutions creates systemic risks and other negative externalities, many argue that financial institutions must rely on extensive debt financing since equity financing is "expensive." Some of the reasons debt is attractive to financial institutions, such as tax benefits and implicit guarantees, are due to subsidies that exacerbate the negative externalities associated with leverage, and are therefore not legitimate from a public policy perspective. Another argument given for high levels of debt financing is that debt serves as a disciplining device for managers who would otherwise make suboptimal or wasteful investment decisions. We propose a mechanism that allows financial institutions to maintain the contractual obligations of debt while avoiding or reducing many of the costs associated with it, including deadweight bankruptcy costs, agency costs due to risk shifting, and under-investment associated with debt overhang. Essentially, we propose a way to increase the liability of the equity issued by the financial institution without changing the limited-liability nature of publicly-held securities. The increased liability is backed by a proposed "Equity Liability Carrier," which holds the increased-liability equity of the financial institution as well as safe liquid assets. In addition to reducing or eliminating the agency problems associated with leverage, this structure concentrates the incentives to monitor and control managers within equity holders, and reduces the need for inefficient liquidation, implicit guarantees and bailouts. Our proposal can be viewed as a way for regulators to impose effectively higher capital requirements, while allowing financial institutions to undertake significant debt commitments.

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Bibliographic Info

Paper provided by Stanford University, Graduate School of Business in its series Research Papers with number 2043.

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Date of creation: Dec 2009
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Handle: RePEc:ecl:stabus:2043

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  1. Thomas Philippon & Philipp Schnabl, 2013. "Efficient Recapitalization," Journal of Finance, American Finance Association, vol. 68(1), pages 1-42, 02.
  2. PETER M. DeMARZO & YULIY SANNIKOV, 2006. "Optimal Security Design and Dynamic Capital Structure in a Continuous-Time Agency Model," Journal of Finance, American Finance Association, vol. 61(6), pages 2681-2724, December.
  3. Grossman, Richard S, 2001. "Double Liability and Bank Risk Taking," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(2), pages 143-59, May.
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Cited by:
  1. Barucci, Emilio & Del Viva, Luca, 2012. "Countercyclical contingent capital," Journal of Banking & Finance, Elsevier, vol. 36(6), pages 1688-1709.

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