Microprudential bank capital regulation in a complex system.

Area of Science:

• Financial economics
• Systemic risk analysis
• Banking regulation

Background:

• Interconnectedness of modern banking systems poses systemic risks.
• Microprudential regulations focus on individual bank health.
• Effectiveness of microprudential capital requirements in preventing cascading failures is debated.

Purpose of the Study:

• To analyze the efficacy of microprudential capital requirements in mitigating bank failure cascades.
• To investigate how these requirements affect the distribution of risk in interconnected banking networks.
• To assess the impact of economic downturn conditions on the effectiveness of these regulations.

Main Methods:

• Agent-based modeling and simulation exercises.
• Network analysis of interconnected banks.
• Varying simulation parameters to mimic economic downturns and different bank responses.

Main Results:

• Microprudential capital requirements redistribute distressed assets, reducing individual failure likelihood.
• These requirements increase the probability of large-scale failure cascades within the banking network.
• The exacerbating effect on cascades is most pronounced under simulated economic downturn conditions.
• Increased bank leverage in response to weaker capital requirements minimally impacts failure cascade size.

Conclusions:

• Current microprudential capital requirements may be counterproductive to mitigating systemic banking crises.
• The redistribution of risk, while aiding individual banks, can amplify systemic vulnerability.
• Policy implications suggest a need to reconsider the design and scope of bank-level capital regulations to address network effects.