DP9618 Market-Based Bank Capital Regulation

Author(s): Jeremy I. Bulow, Paul Klemperer
Publication Date: August 2013
Keyword(s): 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(s): G10, G21, G28, G32
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9618

Today?s 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?.