Too Big to Fail and Optimal Regulation

31 Pages Posted: 1 Feb 2016 Last revised: 25 Mar 2021

See all articles by Chang Ma

Chang Ma

Fudan University - Fanhai International School of Finance (FISF)

Hai Nguyen

The Chinese University of Hong Kong

Date Written: August 29, 2019

Abstract

This paper analyzes the optimal regulation for “Too Big to Fail” (TBTF) in a simple model. As government cannot credibly commit no bail-out during crises, banks have an incentive to become excessively large. In this case, no single policy can fully eliminate the inefficiencies from TBTF. The optimal regulation for the first-best allocation features a capital requirement and issuance of Contingent Convertible Bonds (CoCos) where the capital requirement addresses the moral hazard issue from government bailouts and CoCos improve the risk-sharing. Moreover, a combination of the capital requirement and size regulation can implement a second-best allocation where the government has to bail out the banking sector but the social cost of bail-out is internalized by the banks. In this case, the capital requirement forces banks to internalize the bailout cost while the size regulation directly discourages banks to become large.

Keywords: Too big to fail, bailout, cocos, size regulation

JEL Classification: G21, G28

Suggested Citation

Ma, Chang and Nguyen, Hai, Too Big to Fail and Optimal Regulation (August 29, 2019). Available at SSRN: https://ssrn.com/abstract=2724909 or http://dx.doi.org/10.2139/ssrn.2724909

Chang Ma (Contact Author)

Fudan University - Fanhai International School of Finance (FISF) ( email )

China

Hai Nguyen

The Chinese University of Hong Kong ( email )

Shatin, N.T.
Hong Kong

HOME PAGE: http://https://sites.google.com/site/nxhaivn/

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