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

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. For financial institutions, the correlation bias makes them more prone to fail and raises the level of systemic risk given their interconnectedness. 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