Investor sentiment and limits of arbitrage: Evidence from Chinese stock market

This paper analyzes the optimal regulation for “Too Big to Fail” (TBTF) in a simple model. As the government cannot credibly commit to no bail-out during crises, banks have an incentive to become excessively large ex-ante. 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 an issuance of Contingent Convertible Bonds (CoCos) where the former addresses the moral hazard issue from government bailouts and the latter improves 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.