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A theory of systemic risk and design of prudential bank regulation
Authors:Viral V Acharya  
Institution:aLondon Business School, Regent’s Park, London NW1 4SA, United Kingdom;bStern School of Business, New York University, 44 West 4th St., Suite 9-84, New York, NY 10012, United States;cCEPR, United Kingdom
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:Systemic risk  Crisis  Risk-shifting  Capital adequacy  Bank regulation
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