Too Big to Fail: Toward an Optimal Regulation

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.