A New Capital Regulation For Large Financial Institutions
AbstractWe 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 InfoPaper provided by Fondazione Eni Enrico Mattei in its series Working Papers with number 2009.124.
Date of creation: Dec 2009
Date of revision:
Banks; Capital Requirement; Too Big to Fail;
Other versions of this item:
- Luigi Zingales, 2011. "A New Capital Regulation for Large Financial Institutions," American Law and Economics Review, Oxford University Press, vol. 13(2), pages 453-490.
- Hart, Oliver & Zingales, Luigi, 2009. "A New Capital Regulation For Large Financial Institutions," CEPR Discussion Papers 7298, C.E.P.R. Discussion Papers.
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-01-16 (All new papers)
- NEP-BAN-2010-01-16 (Banking)
- NEP-BEC-2010-01-16 (Business Economics)
- NEP-REG-2010-01-16 (Regulation)
- NEP-RMG-2010-01-16 (Risk Management)
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