Working Paper: CEPR ID: DP7164
Authors: Viral V. Acharya
Abstract: 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.
Keywords: bank regulation; capital adequacy; crisis; risk-shifting; systemic risk
JEL Codes: D62; E58; G21; G28; G38
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| correlation of asset returns (C10) | systemic risk (E44) |
| banks opting for correlated investments (G21) | correlation of asset returns (C10) |
| limited liability + negative externalities (D62) | banks opting for correlated investments (G21) |
| regulatory mechanisms based only on individual bank risk (G28) | exacerbate systemic risk (F65) |
| collective regulation necessary (D70) | mitigate systemic risk (E44) |
| optimal bank closure policies (G28) | minimize forbearance upon joint failures (G33) |
| capital adequacy requirements increase with individual and correlated risks (G32) | optimal regulation (L51) |
| myopic closure policy (E60) | indeterminate correlation choices (C10) |
| systemic risk-shifting arises when banks prefer high correlation (F65) | unmitigated systemic risk-shifting behavior (G40) |
| systemic risk-shifting behavior (G40) | socially optimal outcome (D61) |