John P. Harding & Stephen L. Ross

Abstract

This article applies a model of firm capital structure to the current financial crisis and summarizes the insights the model offers for regulating large financial institutions in a post-crisis world. Firm capital structure is evaluated by examining how firms finance their activities using debt and equity, which reflects an important component of firm risk-taking. The article first summarizes the simple model, then uses its results to interpret the evolution of the financial crisis and place it in context. Finally, it presents forward-looking observations and suggestions for future regulation. The article concludes that any effective new regulatory framework must include a robust method for addressing the expanded “Too Big to Fail” umbrella, which has extended moral hazard risks beyond depository institutions. It argues that a successful framework must impose stringent capital standards on financial institutions, backed by regulators with both the authority and the resolve to enforce those standards—putting owners and managers at risk when violations occur, even during crises when regulators may be tempted to accommodate firms to preserve asset value. The framework should also be flexible enough to adapt to changing financial conditions, especially developments affecting franchise value, and must expose uninsured debtors to risk when capital standards are violated so that debt holders have incentives to monitor the activities of very large financial firms.

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