Capital Adequacy Rules, Catastrophic Firm Failure, and Systemic Risk

15 Pages Posted: 16 Jun 2012

See all articles by Robert A. Jarrow

Robert A. Jarrow

Cornell University - Samuel Curtis Johnson Graduate School of Management

Date Written: June 14, 2012

Abstract

This paper studies capital adequacy rules based on Value-at-Risk (VaR), leverage ratios, and stress testing. VaR is the basis of Basel II, and all three approaches are proposed in Basel III. This paper makes three contributions to the literature. First, we prove that these three rules provide an incentive to increase the probability of catastrophic financial institution failure. Collectively, these rules provide an incentive to increase (not decrease) systemic risk. Second, we argue that an unintended consequence of the Basel II VaR capital adequacy rules was the 2007 credit crisis. Third, we argue that to reduce systemic risk, a new capital adequacy rule is needed. One that is based on a risk measure related to the conditional expected loss given insolvency.

Suggested Citation

Jarrow, Robert A., Capital Adequacy Rules, Catastrophic Firm Failure, and Systemic Risk (June 14, 2012). Johnson School Research Paper Series No. 5-2012. Available at SSRN: https://ssrn.com/abstract=2084200 or http://dx.doi.org/10.2139/ssrn.2084200

Robert A. Jarrow (Contact Author)

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

Department of Finance
Ithaca, NY 14853
United States
607-255-4729 (Phone)
607-254-4590 (Fax)

Register to save articles to
your library

Register

Paper statistics

Downloads
397
rank
70,567
Abstract Views
1,628
PlumX Metrics