A Theory of Systemic Risk and Design of Prudential Bank Regulation

49 Pages Posted: 29 Jan 2009

See all articles by Viral V. Acharya

Viral V. Acharya

New York University (NYU) - Leonard N. Stern School of Business; New York University (NYU) - Department of Finance; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: January 25, 2009

Abstract

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 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. Optimal 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.

Keywords: Systemic risk, Crisis, Risk-shifting, Capital adequacy, Bank regulation

JEL Classification: G21, G28, G38, E58, D62

Suggested Citation

Acharya, Viral V. and Acharya, Viral V., A Theory of Systemic Risk and Design of Prudential Bank Regulation (January 25, 2009). Journal of Financial Stability, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1334457

Viral V. Acharya (Contact Author)

New York University (NYU) - Leonard N. Stern School of Business ( email )

44 West 4th Street
Suite 9-160
New York, NY NY 10012
United States
2129980354 (Phone)
2129954256 (Fax)

HOME PAGE: http://www.stern.nyu.edu/~vacharya

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
2,154
Abstract Views
13,872
Rank
2,531
PlumX Metrics