Do Labyrinthine Legal Limits on Leverage Lessen the Likelihood of Losses? An Analytical Framework
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Lo_Do labyrinthine.pdf
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1.19 MB
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Author(s)
Lo, Andrew W.
Brennan, Thomas J.
Date Issued
January 2012
Journal
Texas Law Review
Publisher
University of Texas School of Law
Citation
Lo, Andrew W. and Thomas J. Brennan. "Do Labrynthine Legal Limits on Leverage Lessen the Likelihood of Losses? An Analytical Framework." Texas Law Review 90:1775 (2012).
Version
Author's final manuscript
Abstract
A common theme in the regulation of financial institutions and transactions is leverage constraints. Although such constraints are implemented in various ways—from minimum net capital rules to margin requirements to credit limits—the basic motivation is the same: to limit the potential losses of certain counterparties. However, the emergence of dynamic trading strategies, derivative securities, and other financial innovations poses new challenges to these constraints. We propose a simple analytical framework for specifying leverage constraints that addresses this challenge by explicitly linking the likelihood of financial loss to the behavior of the financial entity under supervision and prevailing market conditions. An immediate implication of this framework is that not all leverage is created equal, and any fixed numerical limit can lead to dramatically different loss probabilities over time and across assets and investment styles. This framework can also be used to investigate the macroprudential policy implications of microprudential regulations through the general-equilibrium impact of leverage constraints on market parameters such as volatility and tail probabilities.
MIT Department
Sloan School of Management
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Creative Commons Attribution-Noncommercial-Share Alike 3.0
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DOI of Published Version
http://www.texaslrev.com/90-texas-l-rev-1775/
