A theory of systemic risk and design of prudential bank regulation

Viral Acharya

Journal of Financial Stability, 2009, vol. 5, issue 3, 224-255

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: Systemic; risk; Crisis; Risk-shifting; Capital; adequacy; Bank; regulation (search for similar items in EconPapers)
Date: 2009
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Citations: View citations in EconPapers (419)

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Working Paper: A Theory of Systemic Risk and Design of Prudential Bank Regulation (2009)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:finsta:v:5:y:2009:i:3:p:224-255

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