Financial Crisis, Interconnectedness and Regulatory Capital

Abstract

Among the academic and policymaking communities, the recent financial crisis has prompted calls for adopting higher quality regulatory capital requirements that reflect the systemic risk posed by financial institutions and the risks associated with their market interaction. In line with this debate, this paper proposes a simple conceptual methodology for assessing Too-Connected-to-Fail (TCTF) capital charges. TCTF has been recognized as one of the contributing factors to the systemic risk of a financial institution. One clear benefit of TCTF capital charge is that it induces institutions to internalize the costs associated with their interconnection with other institutions and could provide managerial incentives to avoid too much homogeneity among financial institutions and to reduce the reliance on a limited number of counterparties. The TCTF capital charge could also be useful for defining the perimeter of regulation, as the capital charge needs to rely on the incremental contribution to systemic risk of the institution.

Keywords: Too connected to fail, financial crisis, regulatory capital charges, interconnectedness

JEL Classification: G01, G18, G28, G32