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Contagion, Bankruptcy and Social Welfare Analysis in a Financial Economy with Risk Regulation Constraint

Aloisio Araujo and José Valentim Vicente

No 118, Working Papers Series from Central Bank of Brazil, Research Department

Abstract: In the last years, regulatory agencies of many countries in the world, following recomendations of Basel Committee, have compeled financial institutions to maintain a minimum capital requirements to cover market and credit risks. This paper investigates the consequences about social welfare, contagion and the bankruptcy probability of such practice. We show that for each financial institution there is a level of regulation that maximizes its utility. Another important result asserts that risk regulation decreases contagion and under certain conditions can reduce the bankruptcy probability. We also analyze the trade-off faced by regulators involving the financial institutions welfare versus bankruptcy and contagion probabilities.

Date: 2006-10
New Economics Papers: this item is included in nep-reg and nep-rmg
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