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A New Capital Regulation For Large Financial Institutions

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  • Luigi Zingales

    (University of Chicago Booth School of Business)

  • Oliver Hart

    (Harvard University & NBER)

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 an equity cushion sufficiently great that their own credit default swap price stays below a threshold level, and a cushion of long term bonds sufficiently large that, even if the equity is wiped out, the systemically relevant obligations are safe. If the CDS price goes above the threshold, the LFI regulator forces the LFI to issue equity until the CDS price moves back down. If this does not happen within a predetermined period of time, the regulator intervenes. We show that this mechanism ensures that LFIs are always solvent, while preserving some of the disciplinary effects of debt.

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Bibliographic Info

Paper provided by Fondazione Eni Enrico Mattei in its series Working Papers with number 2009.124.

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Date of creation: Dec 2009
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Handle: RePEc:fem:femwpa:2009.124

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Keywords: Banks; Capital Requirement; Too Big to Fail;

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  1. Douglas D. Evanoff & Larry D. Wall, 2000. "Subordinated debt and bank capital reform," Working Paper Series WP-00-7, Federal Reserve Bank of Chicago.
  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. Scott, Hal S. (ed.), 2005. "Capital Adequacy beyond Basel: Banking, Securities, and Insurance," OUP Catalogue, Oxford University Press, number 9780195169713, Octomber.
  4. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
  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. 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.
  7. 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.
  8. 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.
  9. 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.
  10. 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.
  11. 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.
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