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Fat tails and their (un)happy endings : correlation bias and its implications for systemic risk and prudential regulation

Author: Jorge A Chan-Lau; International Monetary Fund. Western Hemisphere Department,
Publisher: [Washington, D.C.] : International Monetary Fund, ©2011.
Series: IMF working paper, WP/11/82.
Edition/Format:   eBook : Document : International government publication : EnglishView all editions and formats
Summary:
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  Read more...
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Genre/Form: Electronic books
Additional Physical Format: Print version:
Fund, International Monetary.
Fat Tails and their (Un)happy Endings: Correlation Bias and its Implications for Systemic Risk and Prudential Regulation.
Washington : International Monetary Fund, ©2011
Material Type: Document, Government publication, International government publication, Internet resource
Document Type: Internet Resource, Computer File
All Authors / Contributors: Jorge A Chan-Lau; International Monetary Fund. Western Hemisphere Department,
ISBN: 1455224014 9781455224012 1283566273 9781283566278 9781462358632 1462358632 9781455226061 1455226068
OCLC Number: 746495284
Description: 1 online resource (22 pages) : illustrations.
Contents: Cover Page; Title Page; Copyright Page; Contents; I. Introduction; II. Understanding the Correlation Bias; A. The Basic Contingent Claim Model; 1. Payoff Schedules of Equity and Debt; B. Tail Risk and Correlation; 2. Profit/Loss of Hypothetical Two-Project Portfolios; C. The Copula Capital Structure Model and the Correlation Bias; 3. The Analogy Between the Capital Structure of a Tranched Structured Product and the Capital Structure of the Firm; 4. Sensitivity of Corporate Claims Value to the Riskiness of a Single Project and to Portfolio Correlation. III. Correlation Bias, Systemic Risk and Prudential RegulationA. Systemic Risk; B. Corporate Governance; C. Prudential Regulation; Contingent Capital and Hybrid Securities; Minimum Capital Requirements; 1. Basel II and Basel III: Capital requirements; Systemic Risk Capital Charges; "Skin-in-the-Game" Measures; IV. What may work against Correlation Bias Risk; A. Reduce Leverage; B. Enforce the Volcker Rule and Portfolio Diversification Requirements; C. Force Originators to Hold "Skin, Flesh, and Bones" in Securitized Products; D. Enhance Corporate Control by Debt Holders; V. Conclusions.
Series Title: IMF working paper, WP/11/82.
Responsibility: Jorge A. Chan Lau.

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.

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