A Theory of Systemic Risk and Design of Prudential Bank Regulation
Viral V. Acharya
New York University - Leonard N. Stern School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); New York University (NYU) - Department of Finance
January 25, 2009
Journal of Financial Stability, Forthcoming
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, D62Accepted Paper Series
Date posted: January 29, 2009
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