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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.

Suggested Citation

  • Chen Zhou, 2010. "Why the micro-prudential regulation fails? The impact on systemic risk by imposing a capital requirement," DNB Working Papers 256, Netherlands Central Bank, Research Department.
  • Handle: RePEc:dnb:dnbwpp:256
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    File URL: https://www.dnb.nl/binaries/Working%20paper%20256_tcm46-237509.pdf
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    References listed on IDEAS

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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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    More about this item

    Keywords

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

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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