Fat-Tails and their (Un)Happy Endings: Correlation Bias and its Implications for Systemic Risk and Prudential Regulation
IMF Working Papers, April 1, 2011
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- Fat-Tails and their (Un)Happy Endings: Correlation Bias and its Implications for Systemic Risk and Prudential Regulation
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Bibliographic details
- Published: April 1, 2011
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781455226061.001
Core findings
- 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.
- A shift toward highly correlated assets makes financial institutions more prone to fail and increases systemic risk given interconnectedness in the financial system.
- The implications for systemic risk and prudential regulation are assessed under the prism of Basel III.
- Potential solutions involve changes to the prudential framework and corporate governance.
Policy implications and recommendations
- Reassess prudential regulation design (Basel III lens) to account for correlation bias that incentivizes asset correlation among firms.
- Consider corporate governance reforms to mitigate shareholders’ incentives to prefer highly correlated assets that raise firm-level and system-level failure probabilities.
- Explore prudential framework changes that internalize the systemic risk externality arising from claim subordination and correlated portfolio choices by financial institutions.
Methodology note
- Analytical approach: copula capital structure model used to demonstrate how claim subordination affects claim holders’ preferred asset correlation and consequent implications for firm failure risk and systemic risk.
Subject classification and keywords
- Subject: Banking, Contingent capital, Stocks, Systemic risk, Tax incentives
- Keywords: asset, capital structure, financial institution, portfolio, shareholder, WP
Authorial/disclaimer note
- This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.
International Monetary Fund — Working Paper No. 2011/082 (April 1, 2011).