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Market-Based Bank Capital Regulation

  • Bulow, Jeremy

    (Stanford University)

  • Klemperer, Paul

    (University of Oxford)

Today's regulatory rules, especially the easily-manipulated measures of regulatory capital, have led to costly bank failures. We design a robust regulatory system such that (i) bank losses are credibly borne by the private sector (ii) systemically important institutions cannot collapse suddenly; (iii) bank investment is counter-cyclical; and (iv) regulatory actions depend upon market signals (because the simplicity and clarity of such rules prevents gaming by firms, and forbearance by regulators, as well as because of the efficiency role of prices). One key innovation is "ERNs" (equity recourse notes--superficially similar to, but importantly distinct from, "cocos") which gradually "bail in" equity when needed. Importantly, although our system uses market information, it does not rely on markets being "right".

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Paper provided by Stanford University, Graduate School of Business in its series Research Papers with number 2132.

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Date of creation: Aug 2013
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Handle: RePEc:ecl:stabus:2132
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