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A New Capital Regulation For Large Financial Institutions

  • Luigi Zingales

    (University of Chicago Booth School of Business)

  • Oliver Hart

    (Harvard University & NBER)

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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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
Date of revision:
Handle: RePEc:fem:femwpa:2009.124
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  1. 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. Scott, Hal S. (ed.), 2005. "Capital Adequacy beyond Basel: Banking, Securities, and Insurance," OUP Catalogue, Oxford University Press, number 9780195169713.
  8. John O’Neill, 2009. "Market," Chapters, in: Handbook of Economics and Ethics, chapter 42 Edward Elgar.
  9. 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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