Macroprudential capital requirements and systemic risk

In the aftermath of the financial crisis, there is interest in reforming bank regulation such that capital requirements are more closely linked to a bank’s contribution to the overall risk of the financial system. In our paper we compare alternative mechanisms for allocating the overall risk of a banking system to its member banks. We explicitly take into account that overall risk as well as each bank’s risk contribution changes once bank capital requirements change and therefore assign capital requirements based on a fixed point at which risk contributions equal capital requirements.To measure how systemic risk changes with bank capital we use a model that explicitly incorporates contagion externalities present in the financial system. We have access to a unique data set of the Canadian banking system, which includes individual banks’ loan books, risk exposures, as well as detailed information on interbank linkages including OTC derivatives. We find that macroprudential capital allocations can differ by as much as 50% from observed capital levels and are not trivially related to bank size or individual bank default probability. Macroprudential capital allocation mechanisms reduce default probabilities of individual banks as well as the probability of a systemic crisis by about 25%. Our results suggest that financial stability can be enhanced substantially by implementing a systemic perspective on bank regulation.