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Market-Based Bank Capital Regulation

68 Pages Posted: 29 Aug 2013 Last revised: 10 Sep 2014

Jeremy Bulow

Stanford University; National Bureau of Economic Research (NBER)

Paul Klemperer

University of Oxford - Department of Economics; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: September 2013

Abstract

Today’s regulatory rules, especially the easily-manipulated measures of regulatory capital, have led to costly bank failures. We design a robust regulatory system such that (i) bank losses are credibly borne by the private sector (ii) systemically important institutions cannot collapse suddenly; (iii) bank investment is counter-cyclical; and (iv) regulatory actions depend upon market signals (because the simplicity and clarity of such rules prevents gaming by firms, and forbearance by regulators, as well as because of the efficiency role of prices). One key innovation is “ERNs” (equity recourse notes -- superficially similar to, but importantly distinct from, “cocos”) which gradually “bail in” equity when needed. Importantly, although our system uses market information, it does not rely on markets being “right.”

Keywords: bail-in, bank, bank capital, bank crisis, capital requirements, contingent capital, contingent convertible bond, debt overhang, deposit insurance, living wills, regulatory capital, regulatory forbearance, SIFI, systemically important financial institution, too-big-to-fail

JEL Classification: G21, G10, G28, G32

Suggested Citation

Bulow, Jeremy and Klemperer, Paul, Market-Based Bank Capital Regulation (September 2013). Rock Center for Corporate Governance at Stanford University Working Paper No. 151 ; Stanford University Graduate School of Business Research Paper No. 2132; Stanford University Graduate School of Business Research Paper No. 13-3; Nuffield College Oxford, Economics Working Paper 2013-W12. Available at SSRN: https://ssrn.com/abstract=2317043 or http://dx.doi.org/10.2139/ssrn.2317043

Jeremy I. Bulow (Contact Author)

Stanford University ( email )

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National Bureau of Economic Research (NBER)

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Paul Klemperer

University of Oxford - Department of Economics ( email )

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United Kingdom
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+44 1865 278 557 (Fax)

Centre for Economic Policy Research (CEPR) ( email )

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United Kingdom

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