A Theory of Systemic Risk and Design of Prudential Bank Regulation

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.

Number of Pages in PDF File: 49

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

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

Accepted Paper Series