Regulatory Capital Charges for Too-Connected-to-Fail Institutions: A Practical Proposal
IMF Working Papers, April 1, 2010
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Bibliographic details
- Authors: Jorge A Chan-Lau
- Published: April 1, 2010
- Series: IMF Working Papers
Summary
- Author: Jorge A Chan-Lau
- Date: April 1, 2010
- Core observation: The recent financial crisis has highlighted once more that interconnectedness in the financial system is a major source of systemic risk.
- Central proposal: Levy regulatory capital charges based on the degree of interconnectedness among financial institutions, specifically grounded on each institution’s incremental contribution to systemic risk.
- Intended effects:
- Internalize the negative externalities associated with too-connected-to-fail institutions.
- Provide managerial incentives to strengthen an institution’s solvency position.
- Reduce excessive homogeneity and reliance on the same counterparties in the financial industry.
Proposal mechanics and analytical basis
- Basis for charges: Institution’s incremental contribution to systemic risk (as stated).
- Analytical elements mentioned: loss distribution, probability of default.
- Targeted risks and subject areas: Asset valuation, Banking, Credit risk, Financial crises, Systemic risk.
- Keywords explicitly used: capital charge, financial system, loss distribution, probability of default, WP.
Policy implications and recommendations
- Implement capital charges calibrated to incremental systemic risk to:
- Encourage institutions to internalize negative externalities from interconnectedness.
- Create incentives for managers to improve solvency and diversify counterparty exposures.
- Mitigate systemic vulnerability stemming from highly connected institutions.