Capital Requirement, “Too Many to Fail” Rescue and Systemic Risk

This paper argues that market price sensitive capital regulation together with financial regulator’s bailout policy can induce banks to herd by investing in highly correlated asset ex ante, thus increase the likelihood of systemic risk ex post. The paper follows Acharya and Yorulmazer’s (2007) study of “Too Many to Fail” problem in a twobank model. They argue that in order to reduce the social loss due to systemic risk of banks failing together, financial regulator finds it ex post optimal to bail out every troubled bank, because acquisition of liquidated asset by other financial institutions could result in high misallocation cost. In contrast to their paper, we argue that as long as it is profitable for banks to purchase the liquidated asset at cash-in-the-market price, the regulator can always commit to randomly bailing out only one bank and let the bailed out bank to purchase failed bank's asset at cash-in-the-market price in the state of systemic riskthere is no "Too Many to Fail" bailout. We then argue that market price sensitive capital regulation can remove banks’ incentive to purchase liquidated asset at low price, because of high cost of capital. Thus, in the state of systemic failure, regulator has to bail out every troubled bank. “Too Many to Fail” rescue arises which then increase bank’s incentive to herd ex ante and high probability of systemic risk ex post.