DP17846 Macroprudential Regulation: A Risk Management Approach
We develop a credit portfolio approach to a Central Bank’s exposure to systemic risk, modeling it as risk arising from holding a portfolio containing (a subset of) the banks the CB supervises. We apply the model to a sample of European banks using CDS prices, which allows the inclusion of non-listed banks. We derive optimal macroprudential capital buffers based on individual banks’ contributions to systemic risk in two steps. First, we minimize aggregate systemic risk subject to an average capital buffer by varying individual buffers while maintaining the average. Then we set that average buffer optimally balancing the social costs and benefits of macroprudential buffers. We find substantial gaps between market-price-based optimal buffers and macroprudential buffers currently in use.
