A Theory of Systemic Risk and Design of Prudential Bank Regulation

Viral Acharya

No 7164, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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 economy-wide 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. 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: Bank regulation; Capital adequacy; Crisis; Risk-shifting; Systemic risk (search for similar items in EconPapers)
JEL-codes: D62 E58 G21 G28 G38 (search for similar items in EconPapers)
Date: 2009-02
New Economics Papers: this item is included in nep-ban, nep-cba, nep-mac, nep-reg and nep-rmg
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Citations: View citations in EconPapers (429)

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