What Matters in Determining Capital Surcharge for Systemically Important Financial Institutions?

What Matters in Determining Capital Surcharge for Systemically Important Financial Institutions?

Céline Gauthier (Bank of Canada, Canada), Toni Gravelle (Bank of Canada, Canada), Xuezhi Liu (Bank of Canada, Canada) and Moez Souissi (Bank of Canada, Canada)
DOI: 10.4018/978-1-4666-2011-7.ch011
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Abstract

One way of internalising the externalities each individual bank imposes on the rest of the financial system is to impose capital surcharges (KS) on them in line with their systemic importance. Given the complexity of the financial system and the resulting difficulties in measuring systemic importance, it is sometimes argued to simply apply higher KS to larger banks, abstracting from other factors like interconnectedness. In this chapter, the authors consider different network structures of the banking system that are characterized by two different centrality measures. Their main finding is that size alone is not always a good proxy for systemic importance and must be supplemented with detailed information on interbank exposures. A relatively small bank playing an outsized role in the interbank market might be more systemic, and thus garner a higher capital surcharge, than a less connected bank of somewhat larger size. Alternatively, if the centrality of banks in an interbank network is positively correlated with their size, then proxies of a bank’s systemic importance largely based on size are sufficient indicators.
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2. Literature Review

Contagion and spillover effects, which are not necessarily appropriately incorporated in market prices ex ante, represent the core amplification channels leading to systemic risk. In the financial literature, we find two main mechanisms through which shocks propagate from one financial institution or market to the other. The first works through direct counterparty credit exposures among individual institutions, and the second through information—imperfections or asymmetry—effects3.

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