Taming Systemically Important Financial Institutions
The research leading to these results has received funding from the European Research Council under the European Community's Seventh Framework Programme (FP7/2007-2013) grant agreement 249415-RMAC, and NCCR Finrisk (project on Banking and Regulation). Xavier Freixas is grateful to Generalitat de Catalunya, Barcelona GSE, Ministerio de Economia y Competitividad-ECO2011-25607, Banco de Espana-Excelencia en Educacion Program. We acknowledge useful comments from the Editor, Ken West, and three anonymous referees, as well as seminar participants at the Bank of Japan, the Studienzentrum in Gerzensee, the IMF, the London School of Economics, the University of Mannheim, in particular Emmanuel Farhi, Hans Gersbach, Florian Heider, Lixin Huang, Marcus Opp, and Rafael Repullo.
We model a systemically important financial institution that is too big (or too interconnected) to fail. Without credible regulation and strong supervision, the shareholders of this institution might deliberately let its managers take excessive risk. We propose a solution to this problem, showing how insurance against systemic shocks can be provided without generating moral hazard. The solution involves levying a systemic tax needed to cover the costs of future crises and more importantly establishing a systemic risk authority endowed with special resolution powers, including the control of bankers’ compensation packages during crisis periods.