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Why the Micro-Prudential Regulation Fails? The Impact on Systemic Risk by Imposing a Capital Requirement

42 Pages Posted: 25 Oct 2011  

Chen Zhou

De Nederlandsche Bank; Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE)

Date Written: July 1, 2010

Abstract

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.

Keywords: banking regulation, systemic risk, capital requirement, macro-prudential regulation

JEL Classification: G01, G28, G32

Suggested Citation

Zhou, Chen, Why the Micro-Prudential Regulation Fails? The Impact on Systemic Risk by Imposing a Capital Requirement (July 1, 2010). De Nederlandsche Bank Working Paper No. 256. Available at SSRN: https://ssrn.com/abstract=1949052 or http://dx.doi.org/10.2139/ssrn.1949052

Chen Zhou (Contact Author)

De Nederlandsche Bank ( email )

PO Box 98
1000 AB Amsterdam
Amsterdam, 1000 AB
Netherlands

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) ( email )

P.O. Box 1738
3000 DR Rotterdam, NL 3062 PA
Netherlands

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