Regulating Capital

Most observers agree that the excessive debt or leverage of systemically important financial institutions (SIFIs) was a central reason why the housing crash of 2007-2009 led to a recession. The Dodd-Frank Act authorizes the Financial Stability Oversight Council and the Federal Reserve to adopt new prudential standards for regulating these institutions. A fundamental challenge for these standards is how to restrain the leverage of SIFIs by prescribing a minimum amount of capital or equity they must hold relative to their assets. This Article develops a framework for the regulation of capital in SIFIs that departs from current regulatory practice. Starting from the assumption of perfect capital markets, it first shows that a limit on leverage is an optimal regulatory policy when capital markets are perfect, but bank failures entail an external social cost. It then argues that capital regulation can be effectively adapted to the imperfections that exist in real financial markets such as taxes, transaction costs, and incomplete information. Many of these imperfections strengthen the argument for capital regulation. In cases where capital regulation may inefficiently reduce lending, suitable regulatory design can mitigate this effect. This Article proposes a security design — automatic convertibles — to mitigate the cost of issuing capital; considers the strategic responses of SIFIs to regulation; and critiques current regulations as well as other market-based proposals in this literature