Monday, April 19, 2010

An Alternative to Obama's Financial Reform Plan

Our proposal, then, is for a new system of regulation that protects the systemically relevant obligations of large financial institutions — making sure they would be repaid by the institution (not by taxpayers) in the case of bankruptcy — but leaves open the possibility that non-systemically relevant obligations will not be protected.

Under this new system, banks would be required to hold two layers of capital to protect their systemically relevant obligations. The first layer would be basic equity — not much different from today's standard capital requirement, except for the fact that the amount of equity required would be determined not by an accounting formula, but by a market assessment of the risk contained in the second layer.

That second layer would consist of so-called "junior long-term debt." Being explicitly labeled "junior" means this debt would be repaid only after the institution has made good on its other debt, and so also means that it would involve more risk for those who buy it (therefore offering higher rates of return). Such debt would provide an added layer of protection to basic equity because, in the event the institution defaulted, the junior long-term debt could be paid back only after other (more systemically relevant) obligations have been repaid. Perhaps most important, because this layer of debt would be traded without the assumption that it would always be protected by federal bailouts, it would make possible a genuine market assessment of its value and risk — and therefore of those of the financial institution itself.

This is the crucial innovation of the approach we propose. The required second layer of capital would allow for a market-based trigger to signal that a firm's equity cushion is thinning, that its long-term debt is potentially in danger, and therefore that the financial institution is taking on too much risk. If that warning mechanism provides accurate signals, and if the regulator intervenes in time, even the junior long-term debt will be paid in full. If either of these two conditions is not met, the institution may burn through some of the junior-debt layer — but its systemically relevant obligations will generally still be secure. In this case, the firm may suffer, but the larger financial system will be kept safe.

Oliver Hart and Luigi Zingales
in The Wall Street Journal

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