Risk Averse Banks and Uncertain Correlation Values: A Theory of Rational Panics

Abstract:     
We present a model for financial fragility in which there is uncertainty over risk management parameters and there is a danger of disinvestment caused by heightened risk aversion. Projects in small economies are assumed to be riskier than those in large economies. In this situation there is a danger that a rise in project correlations will lead to a rational but unnecessary recession. We conclude firstly that greater transparency in the dissemination of correlation parameters is desirable and secondly that regulators should respond to heightened financial fragility by relaxing capital adequacy requirements.

Number of Pages in PDF File: 34

Keywords: Banking, systemic risk, financial fragility, panics, capital adequacy, bank regulation, Value at Risk

JEL Classification: C72, G21, G28

working papers series