DP7164 A Theory of Systemic Risk and Design of Prudential Bank Regulation

Author(s): Viral V. Acharya
Publication Date: February 2009
Keyword(s): Bank regulation, Capital adequacy, Crisis, Risk-shifting, Systemic risk
JEL(s): D62, E58, G21, G28, G38
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7164

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.