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Increased-Liability Equity: A Proposal to Improve Capital Regulation of Large Financial Institutions

25 Pages Posted: 7 Jan 2010 Last revised: 11 Mar 2010

Anat R. Admati

Stanford Graduate School of Business

Paul C. Pfleiderer

Stanford Graduate School of Business

Date Written: March 1, 2010

Abstract

While it is recognized that the high degree of leverage used by financial institutions creates systemic risks and other negative externalities, many argue that equity financing is “expensive,” and that increased capital requirements will increase the cost of credit. Public subsidies of debt financing through tax shields and implicit guarantees may make equity “expensive” but do not make sense given the negative externalities associated with leverage. Some have suggested that debt serves to discipline bank managers who would otherwise make suboptimal or wasteful investment decisions. We propose a way to maintain a high level of contractual debt liabilities on the balance sheets of financial institutions, while at the same time increasing the capital available to support the liabilities. This can be achieved by increasing the liability of the equity of the financial institution and placing it in a separate “Equity Liability Carrier” that also holds safe assets. This reduces fragility and the need for bailouts, and alleviates distortions due to conflicts of interest between debt and equity. We discuss the potential for such structures to address governance issues within financial institutions.

Keywords: capital regulation, financial institutions, capital structure, banking regulation, “too big to fail,” systemic risk

JEL Classification: G21, G28, G32, G38, H81, K23

Suggested Citation

Admati, Anat R. and Pfleiderer, Paul C., Increased-Liability Equity: A Proposal to Improve Capital Regulation of Large Financial Institutions (March 1, 2010). Stanford University Graduate School of Business Research Paper No. 2043; Rock Center for Corporate Governance at Stanford University Working Paper No. 68. Available at SSRN: https://ssrn.com/abstract=1532484 or http://dx.doi.org/10.2139/ssrn.1532484

Anat R. Admati (Contact Author)

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States
650-723-4987 (Phone)
650-725-6152 (Fax)

Paul C. Pfleiderer

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States
650-723-4495 (Phone)
650-725-7979 (Fax)

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