Fat-Tails and their (Un)Happy Endings: Correlation Bias and its Implications for Systemic Risk and Prudential Regulation

Publication Date:

April 1, 2011

Electronic Access:

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Disclaimer: 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

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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