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Why the micro-prudential regulation fails? The impact on systemic risk by imposing a capital requirement

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  • Chen Zhou

Abstract

This paper studies why the micro-prudential regulations fails to maintain a stable financial system by investigating the impact of micro-prudential regulation on the systemic risk in a cross-sectional dimension. We construct a static model for risk-taking behavior of financial institutions and compare the systemic risks in two cases with and without a capital requirement regulation. In a system with a capital requirement regulation, the individual risk-taking of the financial institutions are lower, whereas the systemic linkage within the system is higher. With a proper systemic risk measure combining both individual risks and systemic linkage, we find that, under certain circumstance, the systemic risk in a regulated system can be higher than that in a regulation-free system. We discuss a sufficient condition under which the systemic risk in a regulated system is always lower. Since the condition is based on comparing balance sheets of all institutions in the system, it can be verified only if information on risk-taking behaviors and capital structures of all institutions are available. This suggests that a macro-prudential framework is necessary for establishing banking regulations towards the stability of the financial system as a whole.

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Bibliographic Info

Paper provided by Netherlands Central Bank, Research Department in its series DNB Working Papers with number 256.

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Date of creation: Jul 2010
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Handle: RePEc:dnb:dnbwpp:256

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Keywords: Banking regulation; systemic risk; capital requirement; macro-prudential regulation;

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  1. De Vries, C.G., 2005. "The simple economics of bank fragility," Journal of Banking & Finance, Elsevier, vol. 29(4), pages 803-825, April.
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