| This dissertation develops a theory of why systemic risk, the likelihood of joint failure of banks and financial institutions, arises in equilibrium in a multi-bank and an international context, and proposes means through which such systemic risk can be prudentially regulated.; In the first essay, systemic risk is modeled as the endogenously chosen correlation of returns on assets held by banks. The limited liability of banks and the presence of a negative externality of one bank's failure on the health of other banks give rise to a systemic risk-shifting incentive where all banks undertake correlated investments, thereby increasing economy-wide aggregate risk. Regulatory mechanisms such as bank closure policy and capital adequacy requirements that are commonly based only on a bank's own risk fail to mitigate aggregate risk-shifting incentives, and can, in fact, accentuate systemic risk. Prudential regulation is shown to operate at a collective level, regulating each bank as a function of both its joint (correlated) risk with other banks as well as its individual (bank-specific) risk.; In the second essay, the merit of having international convergence of bank capital requirements in the presence of divergent closure policies of different central banks is examined. Ex-post regulatory policies affect the ex-ante incentives of bankowners. Hence, in prudential regulatory design, the choice of the level of bank capital requirement should vary with the forbearance in central bank's closure policy. The lack of such a linkage leads to a systemic spillover from more forbearing to less forbearing economies, increasing the cost of borrowing and reducing the profits of banks in less forbearing economies. In equilibrium, the central banks of initially less forbearing economies have to adopt greater forbearance as well giving rise to a regression towards the worst closure policy, an outcome that has the potential to destabilize the global banking system. |
