Chapter 18. Regulatory Capital Charges for Too-Connected-to-Fail Institutions: A Practical Proposal

Abstract

The recent financial crisis has highlighted once more that interconnectedness in the financial system is a major source of systemic risk. I suggest a practical way to levy regulatory capital charges based on the degree of interconnectedness among financial institutions. Namely, the charges are based on the institution’s incremental contribution to systemic risk using a risk budgeting approach. The imposition of such capital charges could go a long way toward internalizing the negative externalities associated with too-connected-to-fail institutions and providing managerial incentives to strengthen an institution’s solvency position, and avoid too much homogeneity and excessive reliance on the same counterparties in the financial industry.

Contributor Notes

This chapter was previously published in Financial Markets, Institutions, and Instruments (2010), Vol. 19, No. 5, pp. 355–80 (Chan-Lau, 2010). It has benefited from comments and suggestions from H. Zhu, M. Cerisola, A. Garcia, C. Gauthier, T. Gravelle, M. Kaufmann, B. Johnston, F. Li, L. Lipscomb, O. Melander, J. Mencćia, M. Misina, G. de Nicoló, R. Rennhack, A. Santos, M. Souissi, T. Tressel, K. Tsatsaronis, A. Vamvakidis, Y. Xiao, and seminar participants at the IMF, the Financial Stability Department of the Bank of Canada, the 2010 Bank for International Settlements–Hong Kong Institute for Monetary Research Financial Stability Conference, and the 2010 Financial Crisis Conference at the Bank of Brazil.
Author: Ms. Li L Ong