Title Fat tails and their (un)happy endings : correlation bias and its implications for systemic risk and prudential regulation / Jorge A. Chan Lau

Published [Washington, D.C.] : International Monetary Fund, ©2011

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Description 1 online resource (22 pages) : illustrations Series IMF working paper ; WP/11/82 IMF working paper ; WP/11/82. 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 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 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 Bibliography Includes bibliographical references Subject Asset-liability management -- Econometric models Banks and banking -- Econometric models Banks and banking -- State supervision -- Econometric models Financial risk management -- Econometric models Corporate governance -- Econometric models Banks and banking -- Econometric models Corporate governance -- Econometric models Form Electronic book Author International Monetary Fund. Western Hemisphere Department, issuing body. ISBN 1455224014 9781455224012 1283566273 9781283566278 9781462358632 1462358632 9781455226061 1455226068

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