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A New Capital Regulation for Large Financial Institutions

46 Pages Posted: 11 Jan 2010  

Oliver Hart

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Luigi Zingales

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 3 versions of this paper

Date Written: January 8, 2010

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 an equity cushion sufficiently great that their own credit default swap price stays below a threshold level, and a cushion of long term bonds sufficiently large that, even if the equity is wiped out, the systemically relevant obligations are safe. If the CDS price goes above the threshold, the LFI regulator forces the LFI to issue equity until the CDS price moves back down. If this does not happen within a predetermined period of time, the regulator intervenes. We show that this mechanism ensures that LFIs are always solvent, while preserving some of the disciplinary effects of debt.

Keywords: Banks, Capital Requirement, Too Big to Fail

JEL Classification: G21, G28

Suggested Citation

Hart , Oliver and Zingales, Luigi, A New Capital Regulation for Large Financial Institutions (January 8, 2010). FEEM Working Paper No. 124.2009. Available at SSRN: https://ssrn.com/abstract=1533274 or http://dx.doi.org/10.2139/ssrn.1533274

Oliver D. Hart

Harvard University - Department of Economics ( email )

Littauer Center
Cambridge, MA 02138
United States
617-496-3461 (Phone)
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National Bureau of Economic Research (NBER) ( email )

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Cambridge, MA 02138
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Luigi Zingales (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-702-3196 (Phone)
773-834-2081 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

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