Why the Micro-Prudential Regulation Fails? The Impact on Systemic Risk by Imposing a Capital Requirement
De Nederlandsche Bank; Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE)
July 1, 2010
De Nederlandsche Bank Working Paper No. 256
This paper studies why the micro-prudential regulations fails to maintain a stable financial system by investigating the impact of micro-prudential regulation on the systemic risk in a cross-sectional dimension. We construct a static model for risk-taking behavior of financial institutions and compare the systemic risks in two cases with and without a capital requirement regulation. In a system with a capital requirement regulation, the individual risk-taking of the financial institutions are lower, whereas the systemic linkage within the system is higher. With a proper systemic risk measure combining both individual risks and systemic linkage, we find that, under certain circumstance, the systemic risk in a regulated system can be higher than that in a regulation-free system. We discuss a sufficient condition under which the systemic risk in a regulated system is always lower. Since the condition is based on comparing balance sheets of all institutions in the system, it can be verified only if information on risk-taking behaviors and capital structures of all institutions are available. This suggests that a macro-prudential framework is necessary for establishing banking regulations towards the stability of the financial system as a whole.
Number of Pages in PDF File: 42
Keywords: banking regulation, systemic risk, capital requirement, macro-prudential regulation
JEL Classification: G01, G28, G32
Date posted: October 25, 2011
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