Why Micro-Prudential Regulation Fails? The Impact on Systemic Risk by Imposing a Capital Requirement

This paper investigates why micro-prudential regulations such as capital requirement fail to maintain the stability of a financial system. With a static model on financial institutions' risk-taking behavior, we quantify the impact on systemic risk in the cross-sectional dimension when imposing a capital requirement. Although imposing a capital requirement can lower individual risk, it enhances the systemic linkage within the system at the same time. With a proper systemic risk measure combining both individual risks and systemic linkage, we show that the systemic risk in a regulated system can be higher than that in a regulation-free system. We discuss a sufficient condition under which the systemic risk in a regulated system is always lower. Since the condition is based on comparing both asset and liability sides of bank balance sheets among all institutions in the system, it can be verified only if all required information are available. This suggests that a macro-prudential framework is necessary for establishing banking regulations towards the stability of the entire financial system