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

While it is recognized that the high degree of leverage used by financial institutions creates systemic risks and other negative externalities, many argue that equity financing is “expensive,” and that increased capital requirements will increase the cost of credit. Subsidies of leverage through tax shields and implicit guarantees may make equity “expensive” relative to debt for financial institutions, but they create distorted incentives and do not make sense as part of public policy. Some have suggested that debt serves to discipline bank managers who would otherwise make suboptimal or wasteful investment decisions. We propose a way to maintain a high level of contractual debt obligations on the balance sheets of financial institutions, while at the same time increasing the capital cushion available to support the liabilities. Our proposal creates a way to effectively increase the liability of the equity of the financial institution by placing it in a separate “Equity Liability Carrier” that also holds safe assets and is financed with standard equity. This reduces fragility and the need for bailouts, and it alleviates distortions due to conflicts of interest between debt and equity. We discuss the potential for such structures to address governance issues within financial institutions.

Anat R. Admati and Paul Pfleiderer

Stanford University Graduate School of Business

April 29, 2010

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