Microprudential bank capital regulation in a complex system

Abstract

This paper analyzes the efficacy of microprudential (bank-level) capital requirements in mitigating failure cascades in a network of interconnected banks. In simulation exercises, microprudential capital requirements redistribute the troubled assets of undercapitalized banks more broadly within the network, reducing the immediate likelihood of individual bank failures but increasing the likelihood of large failure cascades. This effect is strongest for simulation parameters that mimic economic downturns. If banks increase leverage in response to weaker capital requirements, failure cascades increase only minimally. These results suggest that current microprudential capital requirements might be counterproductive to the goal of mitigating bank failure cascades.

Keywords: Banks; Financial crises; Financial forecasting and simulation; Government policy and regulation.