Oliver Hart and Luigi Zingales wrote an op-ed with their plan to regulate large financial institutions (LFI) which are too big to fail.  I’ve blogged about their idea before but here it is again quickly:

Suppose a Credit Default Swap CDS pays off if Citibank, say, fails.  Different traders of the Citibank CDS have different information about the chance that Citibank may fail.  The price of the Citibank CDS aggregates that information.  The price will be high if the chance of failure are high.  Hence, a regulator can monitor the Citibank CDS price and step in to force the LFI to cover it loans or be taken over.

They have fleshed this clever plan out with a model but the main idea remains the same.

Here is one problem I see:  If the CDS price is high, the LFI is meant to issue more equity to cover the debt against which CDS is trading.   Suppose it just refuses – i.e. it breaks the rules. In their scheme, the regulator is meant to step in and put the firm in the hands of a receiver who recapitalizes it and sells it.  But this is costly for the regulator.  Maybe the market reacts to the takeover badly and systemic risk spreads through the financial system.  The regulator can instead keep the current managers employed and bail out the LFI using taxpayer money.  If this option makes the managers better off, this is what they will push for.  This is what we see GM doing to avoid bankrupcy for instance, in their case trying to exploit the political risk of bankrupcy rather than systemic risk.

If the threat to enforce rules is not credible, the LFI has the incentive to “hold-up” regulator when the CDS price goes up.  The mechanism proposed by Hart and Zingales is not credible as there is a commitment problem.