Market-Based Bank Capital Regulation
67 Pages Posted: 3 Sep 2013
Date Written: August 2013
Todays 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: G10, G21, G28, G32
Suggested Citation: Suggested Citation