A Theory of Systemic Risk and Design of Prudential Bank Regulation

49 Pages Posted: 29 Jan 2009

See all articles by Viral V. Acharya

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

Multiple version iconThere are 3 versions of this paper

Date Written: January 25, 2009

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.

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

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

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

Viral V. Acharya (Contact Author)

New York University - Leonard N. Stern School of Business ( email )

44 West 4th Street
Suite 9-160
New York, NY NY 10012
United States

HOME PAGE: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/~vacharya.htm

Centre for Economic Policy Research (CEPR)

London
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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