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http://ssrn.com/abstract=2070408
 
 

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Do Labyrinthine Legal Limits on Leverage Lessen the Likelihood of Losses?: An Analytical Framework


Andrew W. Lo


Massachusetts Institute of Technology (MIT) - Sloan School of Management; Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL); National Bureau of Economic Research (NBER)

Thomas J. Brennan


Northwestern University School of Law

May 29, 2012

Texas Law Review, Vol. 90, No. 7, 2012

Abstract:     
A common theme in the regulation of financial institutions and transactions is leverage constraints. Although such constraints are implemented in various ways — from minimum net capital rules to margin requirements to credit limits — the basic motivation is the same: to limit the potential losses of certain counterparties. However, the emergence of dynamic trading strategies, derivative securities, and other financial innovations poses new challenges to these constraints. We propose a simple analytical framework for specifying leverage constraints that addresses this challenge by explicitly linking the likelihood of financial loss to the behavior of the financial entity under supervision and prevailing market conditions. An immediate implication of this framework is that not all leverage is created equal, and any fixed numerical limit can lead to dramatically different loss probabilities over time and across assets and investment styles. This framework can also be used to investigate the macroprudential policy implications of microprudential regulations through the general-equilibrium impact of leverage constraints on market parameters such as volatility and tail probabilities.

Number of Pages in PDF File: 36

Keywords: Leverage, Liquidity, Financial Regulation, Capital Requirements, Macroprudential Policies, Net Capital Rules

JEL Classification: G12, G29, C51, E58, E51

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Date posted: May 30, 2012 ; Last revised: September 5, 2012

Suggested Citation

Lo, Andrew W. and Brennan, Thomas J., Do Labyrinthine Legal Limits on Leverage Lessen the Likelihood of Losses?: An Analytical Framework (May 29, 2012). Texas Law Review, Vol. 90, No. 7, 2012. Available at SSRN: http://ssrn.com/abstract=2070408 or http://dx.doi.org/10.2139/ssrn.2070408

Contact Information

Andrew W. Lo (Contact Author)
Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )
100 Main Street
E62-618
Cambridge, MA 02142
United States
617-253-0920 (Phone)
781 891-9783 (Fax)
HOME PAGE: http://web.mit.edu/alo/www
Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL)
Stata Center
Cambridge, MA 02142
United States
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Thomas J. Brennan
Northwestern University School of Law ( email )
375 E. Chicago Ave
Unit 1505
Chicago, IL 60611
United States
312-503-3233 (Phone)
HOME PAGE: http://www.law.northwestern.edu/faculty/profiles/ThomasBrennan/
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