Unintended Systemic Risk Implication of Regulatory Compliance

The recent financial crisis painfully demonstrated the risk large interconnected banks with complex activities pose to the financial system.  Pre-crisis, microprudential regulation was the norm, where a ‘bottom-up’ approach aimed to protect the consumer from exogenous risk. What is clear now is that a financial system as a whole behaves very differently from its individual component institutions and financial instability stems from endogeneous (within the systemic) risks.  This has meant policymaker’s in developed economies have initiated a myriad of international macroprudential regulatory programs which aim to monitoring and ultimately preventing systemic risk.

The finance literature provides us with some explanations as to why we observe bank herding behaviour which may have systemic risk implications.This literature assesses the incentives through which banks can be correlated with each other.  Specifically, through investment choices (Acharya & Yorulmazer 2007), diversification (Nijskens & Wagner, 2011;Allen et al., 2012), interbank insurance (Kahn & Santos, 2010), or through herding on the liabilities side (Segura & Suarez, 2011; Stein, 2012;Farhi & Tirole, 2012; Horvath & Wagner, 2017).

The economic literature provides an interesting strand on the rationale for the unintended consequences of regulation (Averch & Johnson, 1962; Merton, 1936; Stigler, 1971). These unintended consequences can stem from many sources: human error; the inability to model complex interactions amongst regulated actors; the ‘imperious immediacy’ of a single regulatory interest to the detriment of all others. Our initial findings lend weight to Merton’s (1936) imperious immediacy conjecture.

This project extends recent studies on bank performance, regulations and bank’s business models 1 2 by moving from performance to financial system stability and consider the systemic effects of the regulatory compliance and business model diversity.  We will consider financial stability using a myriad of systemic risk measures 3 which capture a financial institution’s contribution to systemic risk and its exposure to systemic distress.  This will then be used to answer the following questions:

  • Is regulatory compliance providing stability in financial systems?
  • Are supervisors actions engendering financial stability?
  • Are what supervisors are asking banks to do having unintended consequences for financial stability?
  • How sensitive is systemic risk to different forms of financial regulation?
  • Does diversity in banking business models matter for financial stability?
  1. Ayadi, R. et al., 2016. Does Basel compliance matter for bank performance? Journal of Financial Stability, 23, pp.15–32.
  2. Ayadi, R. & Pieter De Groen, W., 2016. Banking Business Models Monitor 2015 EUROPE, Centre for European Policy Studies. Available at: https://www.ceps.eu/system/files/Banking-Business-Models-Monitor-Europe-2015.pdf.
  3. We will use a number of the cross-sectional systemic risk measures described  in Bisias, D. et al., 2012. A survey of systemic risk analytics, Office of Financial Research, US Treasury Department.