FEEM working papers "Note di lavoro" series
2009.124

A New Capital Regulation For Large Financial Institutions


Authors: Oliver Hart, Luigi Zingales
Series: Economy and Society
Editor: Fausto Panunzi
Keywords: Banks, Capital Requirement, Too Big to Fail
JEL n.: G21, G28

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.

Download PDF file

NEWSLETTER FEEM

Subscribe to stay connected.

This website uses cookies to improve user experience. By using our website you consent to all cookies in accordance with our Cookie Policy.   Read moreI agree