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

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