Asset correlation and bank capital regulation: A macroprudential perspective

Abstract

Strong asset correlation across financial institutions may pose a high systemic risk if a common shock negatively affects asset values. In this paper, we present a simple model with multiple banks in which bank defaults are correlated with one another and elicit macroprudential implications of asset correlation on bank capital regulation. We analytically show that if bank failure exhibits an increasing social cost to scale property, the optimal bank capital level becomes higher as asset correlations across banks become stronger. We also apply our analysis into the savings bank crisis in Korea and find empirical evidences supporting the macroprudential importance of asset correlation across banks. Strong asset correlation across banks may lead to the so-called “too-many-to-fail” problem under regulation forbearance. Our findings suggest that, analogously to bank capital surcharges for the systemically important financial institutions to prevent the “too-big-to-fail” problem in the Basel III framework, another bank capital surcharge could preemptively respond to the “too-many-to-fail” problem.