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

April 1, 2011

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Format: Chicago

Fat-Tails and their (Un)Happy Endings: Correlation Bias and its Implications for Systemic Risk and Prudential Regulation, (USA: International Monetary Fund, 2011) accessed December 26, 2024

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.

Subject: Banking, Contingent capital, Stocks, Systemic risk, Tax incentives

Keywords: Asset, Capital structure, Financial institution, Portfolio, Shareholder, WP

Publication Details

Pages:

21
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2011/082
Stock No:

WPIEA2011082
ISBN:

9781455226061
ISSN:

1018-5941

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