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A New Capital Regulation for Large Financial Institutions

  • Oliver Hart
  • Luigi Zingales

We design a new capital requirement for large financial institutions (LFIs) that are "too big to fail." Our mechanism mimics the operation of margin accounts. To ensure LFIs do not default on systemically relevant obligations, we require that they maintain a cushion of equity and junior long-term debt sufficiently great that the credit default swap (CDS) price on the long-term debt stays below a threshold level. If the CDS price moves above the threshold, either LFIs issue equity to bring it down or the regulator intervenes. This mechanism ensures that LFIs are always solvent, while preserving some of the benefits of debt. Copyright 2011, Oxford University Press.

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Article provided by Oxford University Press in its journal American Law and Economics Review.

Volume (Year): 13 (2011)
Issue (Month): 2 ()
Pages: 453-490

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Handle: RePEc:oup:amlawe:v:13:y:2011:i:2:p:453-490
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  1. 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.
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  5. 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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  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. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
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  11. Scott, Hal S. (ed.), 2005. "Capital Adequacy beyond Basel: Banking, Securities, and Insurance," OUP Catalogue, Oxford University Press, number 9780195169713, March.
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