A theory of systemic risk and design of prudential bank regulation

Systemic risk is modeled as the endogenously chosen correlation of returns on assets held by banks. The limited liability of banks and the presence of a negative externality of one bank’s failure on the health of other banks give rise to a systemic risk-shifting incentive where all banks undertake c...

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Bibliographic Details
Published in:Journal of financial stability 2009-09, Vol.5 (3), p.224-255
Main Author: Acharya, Viral V.
Format: Article
Language:English
Subjects:
Bank regulation
Capital adequacy
Crisis
Risk-shifting
Systemic risk
Systemic risk Crisis Risk-shifting Capital adequacy Bank regulation
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Summary:Systemic risk is modeled as the endogenously chosen correlation of returns on assets held by banks. The limited liability of banks and the presence of a negative externality of one bank’s failure on the health of other banks give rise to a systemic risk-shifting incentive where all banks undertake correlated investments, thereby increasing economy-wide aggregate risk. Regulatory mechanisms such as bank closure policy and capital adequacy requirements that are commonly based only on a bank’s own risk fail to mitigate aggregate risk-shifting incentives, and can, in fact, accentuate systemic risk. Prudential regulation is shown to operate at a collective level, regulating each bank as a function of both its joint (correlated) risk with other banks as well as its individual (bank-specific) risk.
ISSN:1572-3089
1878-0962
DOI:10.1016/j.jfs.2009.02.001