Capital Regulation and Bank Failure Contagion

Abstract

I provide simulation evidence that the complex systems framework is well-suited for explaining
the historical distribution of U.S. commercial bank failure cascades. I use the complex systems
framework to test a model of the efficacy of microprudential (bank-level) ratio-based capital
adequacy regulations. I find that these requirements generally have the adverse effect of
increasing the likelihood of large failure cascades. This adverse effect is especially pronounced
under simulation conditions that mimic economic downturns. If banks use more leverage in
response to decreased capital adequacy requirements, the likelihood of failure cascades increases
only minimally. These results suggest that existing microprudential capital adequacy
requirements might be counterproductive to the goal of mitigating bank failure cascades, and
provide theoretical support for a countercyclical capital buffer.

Keywords: Bank Failures, Complex Systems, Systemic Risk, Capital Requirements, Network Structure, Regulatory Policy

JEL Classification: C15, G01, G21, G28