Systemic Risk and Capital Adequacy

Abstract

We assess transmission channels of systemic risk and the effects of capital regulation in the European Banking Union. Two interconnected channels of risk are analysed by employing a data-driven, heterogeneous network model. First, the risk from shocks to corporate, sovereign and retail debt holdings of banks and second, the subsequent contagion effects that spread through the interbank market. A Bayesian approach is used to reconstruct the network of interbank exposures by Gibbs-sampling conditional on publicly available data. The effects of both channels are further magnified by the inclusion of default costs. We provide measures and rankings that aim at a realistic review of the resilience and contagion threat from single banks, countries and different assets. In addition, we draw policy implications from the effectiveness of regulatory capital requirements by applying treatments to the CT1 capital of individual banks in the network. Our findings suggest that the effects of micro prudential regulation fall short of their expected effectiveness. More specifically, the positive results of stricter capital regulation are largely compensated by contagion effects and changes in asset exposures.

Keywords: Systemic Risk, Network Model, Bayesian Network Reconstruction, Contagion Transmission Channels, Bank Regulation, Regulatory Capital

JEL Classification: G21, D85, G01, F37, G28