Prudential policies and systemic risk: The role of interconnections

Abstract

The impact of prudential policies in open economies depends on their intrinsic efficacy and the spillovers from the close financial partners. Using a sample of advanced economies, we find that prudential policy interventions significantly reduce systemic risk in the financial systems with the impact amplified through a network of financial investment links. Using the Spatial Autoregressive (SAR) model we show that the indirect (network) effect enforces the direct effect and accounts for up to 87% of total risk reduction assuming the uniform policy interventions. We are the first to perform a spillover analysis for prudential policies and uncover the importance of financial network and uniform interventions for the reduction of systemic risk.