Abstract

http://ssrn.com/abstract=1334457
 
 

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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 International Finance and Regulation (CIFR); 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

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


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Date posted: January 29, 2009  

Suggested Citation

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: http://ssrn.com/abstract=1334457

Contact Information

Viral V. Acharya (Contact Author)
New York University - Leonard N. Stern School of Business ( email )
44 West 4th Street
New York, NY NY 10012
United States
HOME PAGE: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/~vacharya.htm
Centre for International Finance and Regulation (CIFR) ( email )
Level 7, UNSW CBD Campus
1 O'Connell Street
Sydney, NSW 2000
Australia

Centre for Economic Policy Research (CEPR)
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
New York University (NYU) - Department of Finance
Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
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