Market-based bank capital regulation

Today’s regulatory rules, especially the easily-manipulated measures of regulatory capital, have led to costly bank failures. We design a robust regulatory system such that (i) bank losses are credibly borne by the private sector (ii) systemically important institutions cannot collapse suddenly; (iii) bank investment is counter-cyclical; and (iv) regulatory actions depend upon market signals (because the simplicity and clarity of such rules prevents gaming by firms, and forbearance by regulators, as well as because of the efficiency role of prices). One key innovation is “ERNs” (equity recourse notes--superficially similar to, but importantly distinct from, “cocos”) which gradually "bail in" equity when needed. Importantly, although our system uses market information, it does not rely on markets being “right”. *Bulow: Stanford University; jbulow@stanford.edu. Klemperer: University of Oxford; paul.klemperer@economics.ox.ac.uk. This paper is based upon an Op-Ed written jointly with Jacob Goldfield, and extensive discussions with him. We also particularly thank Peter Blaustein, Iain de Weymarn, Darrell Duffie, Zach Frankel, John Geanakoplos, Andy Haldane, Jeff Horwitz, Thomas Kempner, Antoine Lallour, Will Levine, Ian Martin, Meg Meyer, Pascal Paul, Ken Rogoff, Myron Scholes, Andrei Shleifer, Lawrence Summers, Misa Tanaka, Kevin Warsh, Nancy Zimmerman, and seminar participants at the IMF. Bulow is a member of the Mountain View board of American Century Investment Management Inc.