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A New Capital Regulation For Large Financial Institutions. Oliver Hart Harvard University Luigi Zingales University of Chicago. Motivation . 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. Why?
University of Chicago
=>We propose a market-based mechanism that achieves this goal.
So how do we know when the second cushion of long-term debt is in trouble? One can exercise political pressure on a credit rating agency or a regulator. But it’s hard to influence a market.
Therefore we use price of CDS on LFI junior debt as a trigger, and regulator to coordinate action.
where πis the (risk neutral) probability of default and the recovery rate is the proportion of the value of the debt recovered in the event of default.
The trigger is activated if the CDS price rises and stays above a threshold for an extended period of time. During this period the LFI can raise equity to bring the CDS price back down. If this effort fails and the CDS price stays above the threshold for a predetermined period of time ( say its average over the preceding month exceeds 100 basis points),the regulator intervenes.
(1 – p2)
(1 – p1)
(1 – p3)
In the absence of any debt, the market value of the LFI (which we label VU, i.e., value of the unlevered firm) would be
If we introduce a debt D such that V4 < D < V3, then the market value of the debt VD at issue will be
and the total value of the levered LFI (VL) will be
By diluting the entire value of existing equity, LFI can raise
Hence feasibility requires
which implies that for a debt level D to be made riskless through a margin call it must satisfy
Substituting the value of y, we obtain
where is the (risk neutral) probability of default and the recovery rate is the proportion of the value of the debt recovered in the event of default.
The trigger is activated if the CDS rises and stays above a threshold—in the model, zero-- for an extended period of time. During this period the LFI can raise equity to bring the CDS price back down. If it does not, the regulator intervenes.
Proposition 1: Assume Then the equilibrium price of a CDS, pCDSwill be greater than zero if and only if the lower branch of the tree is followed and the LFI raises equity with value less than D – V4 at date 1.
A) Suppose lower branch and LFI raises less than D – V4 in equity => it cannot be a rational expectations equilibrium for the regulator not to intervene: there is a positive probability that the debt will not be paid at date 2, and the CDS price will reflect this.
B) Lower branch and LFI raises equity equal to D – V4. If the regulator intervenes he will find that the debt is not at risk, and so he will do nothing. The debt is also not at risk if the regulator does not intervene. Thus the unique rational expectations equilibrium in this case is for the CDS price to be zero and for the regulator not to intervene.
C) Upper branch of the tree is followed. Then the debt is not at risk, and so the unique rational expectations equilibrium is one where the CDS price is zero and the regulator does not intervene.
Equity not good because
Affected by the upside
Other debt-like instruments (bonds, yield spreads) good as long as
Not easy to manipulate
CDS is where price discovery first occurs
It leads the stock market (Acharya and Johnson, 2007), the bond market (Blanco et al, 2005) and even the credit rating agencies (Hull et al, 2004).
CDS should be traded in a regulated market and properly collateralized
The junior long-term debt cushion has a double function:
1) It provides a security that can support the CDS
2) It provides an extra layer of protection for the systemic obligations
Minimum amount of long-term debt should be mandated by regulation
Hardly a problem, today it is 19%
The injection of government funds is designed to
Make it politically costly to say that the LFI debt is not at risk
Protect systemically relevant contracts (which are senior) from the regulator’s mistakes
Political cost maximized by making the government claim junior to financial debt
But we want to reduce lobbying pressure from claimholders -> debt senior
Paripassu debt strikes a reasonable balance.
Under the CDS trigger mechanism, no negative NPV investments will be undertaken.
(Bps of premium to insure against default)
1) Which trigger?
2) They do not enhance protection of systemic obligations, only delay bankruptcy
2) The failure of an LFI can force assets’ liquidation leading to downward spiral in asset prices
you are deemed non systemic