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; National Bureau of Economic Research (NBER)
Thomas J. Brennan
Harvard Law School
May 29, 2012
Texas Law Review, Vol. 90, No. 7, 2012
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
Date posted: May 30, 2012 ; Last revised: September 5, 2012
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