Fat-Tails and their (Un)Happy Endings: Correlation Bias and its Implications for Systemic Risk and Prudential Regulation
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Summary:
The correlation bias refers to the fact that claim subordination in the capital structure of the firm influences claim holders’ preferred degree of asset correlation in portfolios held by the firm. Using the copula capital structure model, it is shown that the correlation bias shifts shareholder preferences towards highly correlated assets, making financial institutions more prone to fail and increasing systemic risk given interconnectedness in the financial system. The implications for systemic risk and prudential regulation are assessed under the prism of Basel III, and potential solutions involving changes to the prudential framework and corporate governance are suggested.
Series:
Working Paper No. 2011/082
Subject:
Banking Contingent capital Stocks Systemic risk Tax incentives
English
Publication Date:
April 1, 2011
ISBN/ISSN:
9781455226061/1018-5941
Stock No:
WPIEA2011082
Pages:
21
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