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.