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Does Bank Regulation Retard or Contribute to Systemic Risk?

work, Entrepreneurship, and finance

The prevention of "systemic risk" and a collapse of the banking system is often cited as an objective and rationale for bank regulation and government guarantees, but guarantees and bailouts change the incentives for bank managers and depositors and can lead to an increase in bank failures and losses. Is the net balance favorable, and what might be done to improve it? The paper distinguishes among three different concepts of how a systemic collapse might occur: a large exogenous shock, a failure of one or a few major banks transmitted by a chain reaction among interconnected institutions, and the failure of one bank providing information causing a reassessment of other similar institutions. A key issue becomes whether market participants do a reasonably accurate job of distinguishing insolvent banks from temporarily illiquid ones; that is an empirical question, and some of the evidence is examined. The final section of the paper looks at ways, for each type of systemic risk, in which bank supervisors might improve the efficiency of their actions.

86wp.pdf (220.05 KB)
George G. Kaufman
Kenneth E. Scott
Publication Date
January, 2001