Salience, systemic risk and spectral risk measures as capital requirements

This paper evaluates the effectiveness of macroprudential capital requirements in the form of market risk measures in alleviating systemic risk, fire sales, and welfare losses in crisis resolution. We develop a general equilibrium, heterogeneous agent model with financial institutions subject to risk-based capital requirement constraint and compare the benchmark Value at Risk to three spectral risk measures. The key idea of alternative regulation is probability weighting, by which regulators overweight outcomes that are salient to them relative to their objective probabilities. We show that prudential instruments based on solely overweighting of tail market losses are preferable for policymakers aiming to reduce the likelihood of systemic crises. Overweighting both the downside and upside risks increases household welfare, but results in the financial sector’s risk-seeking preferences and exacerbates the systemic risk. The results suggest that overweighting worst-case and best-case outcomes can prevent fire sales, while overweighting intermediate outcomes leads to welfare improvements of the financial sector after uncertainty shocks.