Regulatory Capital Charges for Too-Connected-to-Fail Institutions: A Practical Proposal
The recent financial crisis has highlighted once more that interconnectedness in the financial system is a major source of systemic risk. I suggest a practical way to levy regulatory capital charges based on the degree of interconnectedness among financial institutions. Namely, the charges are based on the institutionâ€™s incremental contribution to systemic risk. The imposition of such capital charges could go a long way towards internalizing the negative externalities associated with too-connected-to-fail institutions and providing managerial incentives to strengthen an institutionâ€™s solvency position, and avoid too much homogeneity and excessive reliance on the same counterparties in the financial industry.
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