A New Capital Regulation for Large Financial Institutions

30 Pages Posted: 15 Jul 2009

See all articles by Oliver Hart

Oliver Hart

Harvard University - Department of Economics; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Luigi Zingales

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Multiple version iconThere are 3 versions of this paper

Date Written: June 2009

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 a capital cushion sufficiently great that their own credit default swap price stays below a threshold level. If this level is violated the LFI regulator forces the LFI to issue equity until the CDS price moves back below the threshold. If this does not happen within a predetermined period of time, the regulator intervenes. We show that this mechanism ensures that LFIs are solvent with probability one, while preserving the disciplinary effects of debt.

Keywords: banks, Capital requirement, too big to fail

JEL Classification: G21, G28

Suggested Citation

Hart, Oliver D. and Zingales, Luigi, A New Capital Regulation for Large Financial Institutions (June 2009). CEPR Discussion Paper No. DP7298, Available at SSRN: https://ssrn.com/abstract=1433893

Oliver D. Hart

Harvard University - Department of Economics ( email )

Littauer Center
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National Bureau of Economic Research (NBER) ( email )

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European Corporate Governance Institute (ECGI) ( email )

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Luigi Zingales (Contact Author)

University of Chicago - Booth School of Business ( email )

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Chicago, IL 60637
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773-702-3196 (Phone)
773-834-2081 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
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United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

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