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A Theory of Systemic Risk and Design of Prudential Bank Regulation

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Author Info
Acharya, Viral V.

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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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7164.

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Date of creation: Feb 2009
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Handle: RePEc:cpr:ceprdp:7164

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Related research
Keywords: Bank regulation; Capital adequacy; Crisis; Risk-shifting; Systemic risk;

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Find related papers by JEL classification:
D62 - Microeconomics - - Welfare Economics - - - Externalities
E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Mortgages
G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation

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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Viral Acharya & Tanju Yorulmazer, . "Cash-in-the-market pricing and optimal resolution of bank failures," Bank of England working papers 328, Bank of England. [Downloadable!]
    Other versions:
  2. Olivier De Jonghe, 2009. "Back to the basics in banking ? A micro-analysis of banking system stability," Research series 200906-26, National Bank of Belgium. [Downloadable!]
    Other versions:
  3. Acharya, Viral V & Hasan, Iftekhar & Saunders, Anthony, 2002. "The Effects of Focus and Diversification on Bank Risk and Return: Evidence from Individual Bank Loan Portfolios," CEPR Discussion Papers 3252, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  4. Yaron Leitner, 2004. "Financial networks: contagion, commitment, and private sector bailouts," Working Papers 02-9, Federal Reserve Bank of Philadelphia. [Downloadable!]
  5. Acharya, Viral V & Yorulmazer, Tanju, 2005. "Cash-in-the-Market Pricing and Optimal Bank Bailout Policy," CEPR Discussion Papers 5154, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  6. Wagner, Wolf, 2006. "Diversification at financial institutions and systemic crises," Discussion Paper 71, Tilburg University, Center for Economic Research. [Downloadable!]
  7. Martin Summer, 2003. "Banking Regulation and Systemic Risk," Open Economies Review, Springer, vol. 14(1), pages 43-70, January. [Downloadable!] (restricted)
    Other versions:
  8. Chakraborty, Suparna & Allen, Linda, 2007. "Revisiting the Level Playing Field: International Lending Responses to Divergences in Japanese Bank Capital Regulations from the Basel Accord," MPRA Paper 1805, University Library of Munich, Germany. [Downloadable!]
  9. Shirley HO, 2004. "Evolutionary Forces in a Banking System with Speculation and System Risk," Econometric Society 2004 Far Eastern Meetings 692, Econometric Society. [Downloadable!]
  10. Tanaka, Misa, 2002. "How Do Bank Capital and Capital Adequacy Regulation Affect the Monetary Transmission Mechanism?," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
  11. Dimitrios Tsomocos & Sudipto Bhattacharya & Charles Goodhart & Pojanart Sunirand, 2007. "Banks, relative performance, and sequential contagion," Economic Theory, Springer, vol. 32(2), pages 381-398, August. [Downloadable!] (restricted)
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  12. Acharya, Viral V & Yorulmazer, Tanju, 2003. "Information Contagion and Inter-Bank Correlation in a Theory of Systemic Risk," CEPR Discussion Papers 3743, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  13. Allen N. Berger & Gregory F. Udell, 2003. "The institutional memory hypothesis and the procyclicality of bank lending behavior," Finance and Economics Discussion Series 2003-02, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  14. Hege, Ulrich & Feess, Eberhard, 2007. "Basel II and the Value of Bank Differentiation," Les Cahiers de Recherche 879, HEC Paris. [Downloadable!]
  15. Barnhill, Theodore M. & Souto, Marcos Rietti, 2008. "Systemic bank risk in Brazil: an assessment of correlated market, credit, sovereign and inter-bank risk in an environment with stochastic volatilities and correlations," Discussion Paper Series 2: Banking and Financial Studies 2008,13, Deutsche Bundesbank, Research Centre. [Downloadable!]
  16. Eberhard Feess & Ulrich Hege, 2004. "The Basel II Accord: Internal Ratings and Bank Differentiation," CFS Working Paper Series 2004/25, Center for Financial Studies. [Downloadable!]
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