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A theory of systemic risk and design of prudential bank regulation

  • Acharya, Viral V.

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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Article provided by Elsevier in its journal Journal of Financial Stability.

Volume (Year): 5 (2009)
Issue (Month): 3 (September)
Pages: 224-255

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Handle: RePEc:eee:finsta:v:5:y:2009:i:3:p:224-255
Contact details of provider: Web page: http://www.elsevier.com/locate/jfstabil

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