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A New Capital Regulation For Large Financial Institutions

Author

Listed:
  • Luigi Zingales

    (University of Chicago Booth School of Business)

  • Oliver Hart

    (Harvard University & NBER)

Abstract

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.

Suggested Citation

  • Luigi Zingales & Oliver Hart, 2009. "A New Capital Regulation For Large Financial Institutions," Working Papers 2009.124, Fondazione Eni Enrico Mattei.
    • Handle: RePEc:fem:femwpa:2009.124
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    References listed on IDEAS

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    Keywords

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    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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