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Rock Center for Corporate Governance Faculty Lunch with Anat Admati and Paul Pfleiderer

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November 19, 2009 12:00pm - 1:30pm

Anat R. Admati (Stanford Graduate School of Business) and Paul Pfleiderer (Stanford Graduate School of Business) will be presenting their recent research on “Increased-Liability Equity: A Proposal to Improve Capital Regulation of Large Financial Institutions”

Abstract:

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 not legitimate from a public policy perspective. Another argument that favors debt financing is that debt serves as a disciplining device for managers who would otherwise make suboptimal or wasteful investment decision. To the extent that for this or other reasons it is judged that financial institutions should be allowed to take on significant levels of debt, we propose a mechanism that maintains 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. The proposed structure also reduces need for implicit guarantees and bailouts. 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. This would allow regulators to effectively increase the capital requirements while still allowing financial institutions to undertake significant leverage.