A Theory of Systemic Risk and Design of Prudential Bank Regulation

51 Pages Posted: 18 Feb 2009

See all articles by Viral V. Acharya

Viral V. Acharya

New York University - Leonard N. Stern School of Business; New York University (NYU) - Department of Finance; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: February 2009

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 Classification: D62, E58, G21, G28, G38

Suggested Citation

Acharya, Viral V., A Theory of Systemic Risk and Design of Prudential Bank Regulation (February 2009). CEPR Discussion Paper No. DP7164, Available at SSRN: https://ssrn.com/abstract=1345690

Viral V. Acharya (Contact Author)

New York University - Leonard N. Stern School of Business ( email )

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New York, NY NY 10012
United States

HOME PAGE: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/~vacharya.htm

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
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1000 Brussels
Belgium

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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