DP7164 A Theory of Systemic Risk and Design of Prudential Bank Regulation

Author(s): Viral V. Acharya

Publication Date: February 2009

Keyword(s): Bank regulation , Capital adequacy , Crisis , Risk-shifting , Systemic risk

JEL(s): D62 , E58 , G21 , G28 , G38

Programme Areas: Financial Economics

Link to this Page: www.cepr.org/pubs/dps/DP7164.asp.asp

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.