A New Capital Regulation For Large Financial Institutions

If there is one lesson to be learned from the 2008 financial crisis, it is that large financial institutions (LFIs) are too big to fail. Whether the too-big-to-fail doctrine is based on economic thinking (the cost of a large failure is too high) or political reality (the pressure to save LFIs is too strong), the conclusion is the same: we need to rethink how we regulate these institutions. In A New Capital Regulation For Large Financial Institutions, which I recently presented at the Law, Economics and Organizations seminar here at Harvard Law School, my co-author Luigi Zingales and I view the goal of regulation as being to preserve the incentive effects of bankruptcy while avoiding the possibility that an LFI is insolvent with respect to its systemic obligations: interbank lending, derivatives and deposits.

We introduce a new capital requirement system designed specifically for LFIs. Our mechanism mimics the way margin calls function. LFIs will post enough collateral (equity) to ensure that the debt (all the debt, not just the deposits and derivative contracts) is paid in full with probability one. When the fluctuation in the value of the underlying assets puts debt at risk, LFI equity holders are faced with a margin call and they must either inject new capital or lose their equity. There are three main differences between margin calls and our new capital requirement system: the trigger mechanism, the action taken if the trigger is activated, and the presence of an additional cushion of junior long-term debt.

First, unlike a margin account, the underlying assets in our mechanism-commercial loans and home equity lines, for example-are not standardized and not frequently traded. Thus it is not easy to determine when the margin is too thin to protect the existing debt. In addition, debt holders are often dispersed and so unable to coordinate a margin call. If a margin call approach is to be followed, we need to find an easily observable trigger. To solve this problem we rely on the credit default swap (CDS) market as a trigger mechanism. A credit default swap on an LFI is an insurance claim that pays off if the LFI fails and creditors are not paid in full. Since the CDS is a “bet” on the institution’s strength, its price reflects the probability that the debt will not be repaid in full. In essence, the CDS indicates the risk that the LFI will fail. In our mechanism, when the CDS price rises above a critical threshold, the regulator forces the LFI to issue equity until the CDS price moves back below the threshold. If this does not happen within a predetermined period of time the regulator intervenes.

The second difference from a standard margin call system is precisely this role of the regulator. The regulator first determines whether the LFI debt is at risk – in effect, she carries out a stress test. If the debt is not at risk (i.e., the CDS prices were inaccurate), then the regulator declares the company adequately capitalized and to prove it injects some government money. If the debt is at risk, the regulator replaces the CEO with a receiver (or trustee), who recapitalizes and sells the company, ensuring in the process that shareholders are wiped out and creditors receive a haircut. This regulatory takeover–which is very similar to the way the FDIC currently intervenes when a commercial bank gets into trouble–can be thought of as a milder form of bankruptcy, and it achieves the goals of bankruptcy (discipline on the investors and management) without imposing any of the costs (systemic effects).

Finally, the third difference from a standard margin call system is that to protect the systemic obligations, besides the equity cushion, we require also a layer of junior long- term debt. This debt has a dual function, to provide an additional cushion for the systemic obligations and to provide the underlying asset on which the CDS is traded.

One of the advantages of our approach is that it is easily applicable to all financial institutions regardless of their organizational structure. One of the weaknesses of the current capital requirement system is that it applies only to certain types of institutions (commercial banks, but not investment banks or hedge funds), creating ample opportunity for regulatory arbitrage. In contrast, our rule can be applied to all financial institutions holding assets in excess of a predetermined threshold ($200 billion, say).

The full paper is available for download here.

Oliver Hart is the Andrew E. Furer Professor of Economics at Harvard University.

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One Comment

  1. Michael F. Martin
    Posted Wednesday, November 11, 2009 at 2:46 pm | Permalink

    I like the idea of bundling CDS prices with CDO prices — in effect, introducing active negative feedback. But I don’t see how this plan avoids systemic risk in the sense that there is nothing to short-circuit cascading failures from one market to another. Perhaps it makes such cascading failures slightly less frequent, and perhaps that’s enough. But it doesn’t seem to address the fundamental problem of cross-linkages between otherwise unrelated bundles of risk created by LFIs.