DP17846 Macroprudential Regulation: A Risk Management Approach
We address the problem of regulating the size of banks’ macroprudential capital buffers by using market-based estimates of systemic risk combined with a structural framework for credit risk assessment. We develop a set of novel models through which capital buffers can be allocated across systemic banks: (1) equalizing the expected impact between a systemic and a non-systemic institution; (2) minimizing the aggregate systemic risk; (3) balancing the social costs and benefits of higher capital requirements. We apply the model to the European banking sector and find sometimes substantial differences with the capital buffers currently assigned by national regulators. As capital buffers are one of the main policy instruments for managing banks’ potential contributions to systemic distress, our findings have material implications for systemic risk in the EEA.