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A New Capital Regulation for Large Financial Institutions

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  • Oliver Hart
  • Luigi Zingales

Abstract

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.

Suggested Citation

  • Oliver Hart & 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.
    • Handle: RePEc:oup:amlawe:v:13:y:2011:i:2:p:453-490
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    File URL: http://hdl.handle.net/10.1093/aler/ahr001
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    More about this item

    JEL classification:

    • 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

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