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Fat-Tails and their (Un)Happy Endings: Correlation Bias and its Implications for Systemic Risk and Prudential Regulation

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  • International Monetary Fund

Abstract

The correlation bias refers to the fact that claim subordination in the capital structure of the firm influences claim holders’ preferred degree of asset correlation in portfolios held by the firm. Using the copula capital structure model, it is shown that the correlation bias shifts shareholder preferences towards highly correlated assets, making financial institutions more prone to fail and increasing systemic risk given interconnectedness in the financial system. The implications for systemic risk and prudential regulation are assessed under the prism of Basel III, and potential solutions involving changes to the prudential framework and corporate governance are suggested.

Suggested Citation

  • International Monetary Fund, 2011. "Fat-Tails and their (Un)Happy Endings: Correlation Bias and its Implications for Systemic Risk and Prudential Regulation," IMF Working Papers 2011/082, International Monetary Fund.
    • Handle: RePEc:imf:imfwpa:2011/082
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    References listed on IDEAS

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    1. Scharfstein, David S & Stein, Jeremy C, 1990. "Herd Behavior and Investment," American Economic Review, American Economic Association, vol. 80(3), pages 465-479, June.
    2. Mr. Jorge A Chan-Lau, 2001. "The Impact of Corporate Governance Structures on the Agency Cost of Debt," IMF Working Papers 2001/204, International Monetary Fund.
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    Cited by:

    1. Giuseppe Mastromatteo & Giuseppe Mastromatteo, 2016. "Minsky at Basel: A Global Cap to Build an Effective Postcrisis Banking Supervision Framework," Economics Working Paper Archive wp_875, Levy Economics Institute.

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