A New Capital Regulation for Large Financial Institutions

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A New Capital Regulation for Large Financial Institutions

by Oliver Hart, Harvard University
Luigi Zingales, University of Chicago

June 2009

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 a capital cushion sufficiently great that their own credit default swap price stays below a threshold level. If this level is violated the LFI 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. We show that this mechanism ensures that LFIs are solvent with probability one, while preserving the disciplinary effects of debt.

JEL Classification: G21, G28.

Keywords: banks, capital requirement and too big to fail.

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