A Microfounded Design of Interconnectedness-Based Macroprudential Regulation

The failure of large, complex and interconnected banks has severe consequences to the real economy. To address the challenges posed by globally systemically important banks (G-SIBs), the Basel Committee on Banking Supervision recommended an “additional loss absorbency requirement” for these institutions. Motivated by this instrument of macroprudential regulation, which reflects concern over contagion, I develop a microfounded design of interconnectedness-based capital charges. These charges increase the costs of establishing interbank connections, which leads to a non-monotonic welfare effect. While reduced interconnectedness decreases welfare by restricting banks’ ability to insure against liquidity shocks, it also increases it by reducing contagion in default states. Thus, the regulator faces a trade-off between efficiency and financial stability. I show that the trade-off implied by incentive compatible interconnectedness-based charges is steeper the stronger G-SIBs implicit support is when banks’ tail risk exposure is private information. This finding underscores the importance of complementary measures, such as resolution regimes, which mitigate these frictions and consequently reinforce the efficiency and effectiveness of these capital requirements.