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Capital adequacy rules, catastrophic firm failure, and systemic risk

Author

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  • Robert Jarrow
Abstract
This paper studies capital adequacy rules based on Value-at-Risk (VaR), leverage ratios, and stress testing. VaR is the basis of Basel II, and all three approaches are proposed in Basel III. This paper makes three contributions to the literature. First, we prove that these three rules provide an incentive to increase the probability of catastrophic financial institution failure. Collectively, these rules provide an incentive to increase (not decrease) systemic risk. Second, we argue that an unintended consequence of the Basel II VaR capital adequacy rules was the 2007 credit crisis. Third, we argue that to reduce systemic risk, a new capital adequacy rule is needed. One that is based on a risk measure related to the conditional expected loss given insolvency. Copyright Springer Science+Business Media New York 2013

Suggested Citation

  • Robert Jarrow, 2013. "Capital adequacy rules, catastrophic firm failure, and systemic risk," Review of Derivatives Research, Springer, vol. 16(3), pages 219-231, October.
    • Handle: RePEc:kap:revdev:v:16:y:2013:i:3:p:219-231
    DOI: 10.1007/s11147-013-9088-2
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    References listed on IDEAS

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    1. Ines Drumond, 2009. "Bank Capital Requirements, Business Cycle Fluctuations And The Basel Accords: A Synthesis," Journal of Economic Surveys, Wiley Blackwell, vol. 23(5), pages 798-830, December.
    2. Frederick T. Furlong & Michael C. Keeley, 1991. "Capital regulation and bank risk-taking: a note (reprinted from Journal of Banking and Finance)," Economic Review, Federal Reserve Bank of San Francisco, issue Sum, pages 34-39.
    3. repec:bla:jfinan:v:43:y:1988:i:5:p:1219-33 is not listed on IDEAS
    4. Berger, Allen N. & Herring, Richard J. & Szego, Giorgio P., 1995. "The role of capital in financial institutions," Journal of Banking & Finance, Elsevier, vol. 19(3-4), pages 393-430, June.
    5. Gary Gorton, 2009. "The Subprime Panic," European Financial Management, European Financial Management Association, vol. 15(1), pages 10-46, January.
    6. Jarrow, Robert, 2013. "A leverage ratio rule for capital adequacy," Journal of Banking & Finance, Elsevier, vol. 37(3), pages 973-976.
    7. Heid, Frank, 2007. "The cyclical effects of the Basel II capital requirements," Journal of Banking & Finance, Elsevier, vol. 31(12), pages 3885-3900, December.
    8. Robert Jarrow, 2002. "Put Option Premiums and Coherent Risk Measures," Mathematical Finance, Wiley Blackwell, vol. 12(2), pages 135-142, April.
    9. Kahane, Yehuda, 1977. "Capital adequacy and the regulation of financial intermediaries," Journal of Banking & Finance, Elsevier, vol. 1(2), pages 207-218, October.
    10. Blum, Jurg, 1999. "Do capital adequacy requirements reduce risks in banking?," Journal of Banking & Finance, Elsevier, vol. 23(5), pages 755-771, May.
    11. Rochet, Jean-Charles, 1992. "Capital requirements and the behaviour of commercial banks," European Economic Review, Elsevier, vol. 36(5), pages 1137-1170, June.
    12. Robert Jarrow, 2007. "A Critique of Revised Basel II," Journal of Financial Services Research, Springer;Western Finance Association, vol. 32(1), pages 1-16, October.
    13. Furlong, Frederick T. & Keeley, Michael C., 1989. "Capital regulation and bank risk-taking: A note," Journal of Banking & Finance, Elsevier, vol. 13(6), pages 883-891, December.
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    Cited by:

    1. Olivier Bruno & André Cartapanis & Eric Nasica, 2013. "Bank leverage, financial fragility and prudential regulation," Working Papers halshs-00853701, HAL.
    2. Wall, Larry, 2014. "Measuring capital adequacy: supervisory stress-tests in a Basel world," Journal of Financial Perspectives, EY Global FS Institute, vol. 2(1), pages 85-94.
    3. Koch-Medina, Pablo & Munari, Cosimo, 2016. "Unexpected shortfalls of Expected Shortfall: Extreme default profiles and regulatory arbitrage," Journal of Banking & Finance, Elsevier, vol. 62(C), pages 141-151.
    4. Valeria Bignozzi & Matteo Burzoni & Cosimo Munari, 2020. "Risk Measures Based on Benchmark Loss Distributions," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 87(2), pages 437-475, June.
    5. Douglas da Rosa München & Herbert Kimura, 2020. "Regulatory Banking Leverage: what do you know?," Working Papers Series 540, Central Bank of Brazil, Research Department.

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    More about this item

    Keywords

    Value at risk; Leverage ratios; Catastrophic failure; Systemic risk; G21; G28; E58;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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