A Microfounded Design of Interconnectedness-Based Macroprudential Regulation

Jose Fique (jfique@imap.iu.edu)
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Jose Fique: Indiana University

No 2015-008, CAEPR Working Papers from Center for Applied Economics and Policy Research, Department of Economics, Indiana University Bloomington

Abstract: The failure of large, complex and interconnected banks has severe consequences to the real economy. To address the challenges posed by globally systemically important banks (G-SIBs), the Basel Committee on Banking Supervision recommended an “additional loss absorbency requirement” for these institutions. Motivated by this instrument of macroprudential regulation, which reflects concern over contagion, I develop a microfounded design of interconnectedness-based capital charges. These charges increase the costs of establishing interbank connections, which leads to a non-monotonic welfare effect. While reduced interconnectedness decreases welfare by restricting banks’ ability to insure against liquidity shocks, it also increases it by reducing contagion in default states. Thus, the regulator faces a trade-off between efficiency and financial stability. I show that the trade-off implied by incentive compatible interconnectedness-based charges is steeper the stronger G-SIBs implicit support is when banks’ tail risk exposure is private information. This finding underscores the importance of complementary measures, such as resolution regimes, which mitigate these frictions and consequently reinforce the efficiency and effectiveness of these capital requirements.

Keywords: Asymmetric Information; Counterparty Risk; Network Formation; Regulation (search for similar items in EconPapers)
JEL-codes: D82 D85 G01 G21 G28 (search for similar items in EconPapers)
Pages: 40 pages
Date: 2015-04
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Persistent link: https://EconPapers.repec.org/RePEc:inu:caeprp:2015008

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