Highly leveraged institutions: Possible regulatory responses

The experience of Long‐Term Capital Management (LTCM) demonstrated various ways in which highly leveraged institutions (HLIs) can threaten the stability of financial markets. This has sparked a policy debate about the possible responses by the authorities to reduce those threats. This paper attempts to take a step back from that policy debate. It summarises briefly what economic theory says are the fundamental reasons for regulatory intervention in any form of financial services business — essentially that there is a market failure to correct. It assesses the way in which HLIs may contribute to various of those types of market failure. And it runs through the proposals which have so far emerged for dealing with the weaknesses shown up by LTCM, showing how each corrects for the market failure in question, how big the benefits delivered by that correction are, and questioning how far the benefits justify the costs of implementing it.