Increased-Liability Equity: A Proposal to Improve Capital Regulation of Large Financial Institutions

Increased-Liability Equity: A Proposal to Improve Capital Regulation of Large Financial Institutions

March 1,2010Working Paper No. 2043

While it is recognized that the high degree of leverage used by financial institutions creates systemic risks and other negative externalities, many argue that financial institutions must rely on extensive debt financing since equity financing is expensive. Some of the reasons debt is attractive to financial institutions, such as tax benefits and implicit guarantees, are due to subsidies that exacerbate the negative externalities associated with leverage, and are therefore not legitimate from a public policy perspective. Another argument given for high levels of debt financing is that debt serves as a disciplining device for managers who would otherwise make suboptimal or wasteful investment decisions. We propose a mechanism that allows financial institutions to maintain the contractual obligations of debt while avoiding or reducing many of the costs associated with it, including deadweight bankruptcy costs, agency costs due to risk shifting, and under-investment associated with debt overhang. Essentially, we propose a way to increase the liability of the equity issued by the financial institution without changing the limited-liability nature of publicly-held securities. The increased liability is backed by a proposed Equity Liability Carrier, which holds the increased-liability equity of the financial institution as well as safe liquid assets. In addition to reducing or eliminating the agency problems associated with leverage, this structure concentrates the incentives to monitor and control managers within equity holders, and reduces the need for inefficient liquidation, implicit guarantees and bailouts. Our proposal can be viewed as a way for regulators to impose effectively higher capital requirements, while allowing financial institutions to undertake significant debt commitments.

Keywords
corporate finance, banking regulation, too big to fail, systemic risk, corporate control and organization, regulation of financial institutions, corporate governance law, capital regulation