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Correlated Default Risks and Bank Regulations

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  • Chen, Andrew H.
  • Ju, Nengjiu
  • Mazumdar, Sumon C.
  • Verma, Avinash

Abstract

Bank regulatory design relies critically on bank risk modeling. Traditionally, the bank's aggregate value is assumed to obey an exogenously specified process (e.g., a lognormal diffusion). We demonstrate that this assumption is generally invalid given the truncated and correlated payoff structure of individual bank loans. Instead, the bank's aggregate terminal payoff is significantly (left) fat tailed. This skewness remains even when the bank holds an infinitely large number of loans in its portfolio unless they are uncorrelated. By ignoring skewness in bank payoffs, deposit insurance premia and capital requirements have traditionally been significantly mis-calculated.

Suggested Citation

  • Chen, Andrew H. & Ju, Nengjiu & Mazumdar, Sumon C. & Verma, Avinash, 2006. "Correlated Default Risks and Bank Regulations," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(2), pages 375-398, March.
  • Handle: RePEc:mcb:jmoncb:v:38:y:2006:i:2:p:375-398
    DOI: 10.1353/mcb.2006.0028
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    Cited by:

    1. repec:bpj:strimo:v:34:y:2017:i:1-2:p:55-67:n:1 is not listed on IDEAS
    2. Stefan Nagel & Amiyatosh Purnanandam, 2019. "Bank Risk Dynamics and Distance to Default," NBER Working Papers 25807, National Bureau of Economic Research, Inc.
    3. Atreya, Nikhil & Mjøs, Aksel & Persson, Svein-Arne, 2015. "Making Bank: Why High Bank Leverage is Optimal - for the Bank's Shareholders," Discussion Papers 2015/33, Norwegian School of Economics, Department of Business and Management Science.
    4. repec:zbw:kdijep:200811 is not listed on IDEAS
    5. Peleg Lazar, Sharon & Raviv, Alon, 2019. "The Risk Spiral: The Effects of Bank Capital and Diversification on Risk Taking," MPRA Paper 92134, University Library of Munich, Germany.
    6. Dermine, Jean, 2015. "Basel III leverage ratio requirement and the probability of bank runs," Journal of Banking & Finance, Elsevier, vol. 53(C), pages 266-277.

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