In the paper, Capital Adequacy Rules, Catastrophic Firm Failure, and Systemic Risk, which was recently made publicly available on SSRN, I study capital adequacy rules based on Value-at-Risk (VaR), leverage ratios, and stress testing. VaR is the basis of Basel II, and all three approaches are proposed in Basel III.

Due to the 2007 credit crisis, the need for increased regulatory capital has been addressed by newly enacted legislation in the Dodd Frank Wall Street Reform and Consumer Protection Act, and the Basel III capital proposals. The existing and proposed capital adequacy rules are based on three methodologies: Value- at-Risk (VaR), maximum leverage ratios, and stress testing. The purpose of this paper is to analyze the impact of these three rules on the likelihood of financial institution catastrophic failure, and systemic risk in the economy.

A related literature on bank capital concerns the impact of capital regulation on bank risk taking behavior and the business cycle. Kahane (1977), Kim and Santomero (1988), Furlong and Keeley (1989), Rochet (1992), and Blum (1999) study models to determine if capital regulations decrease the risk of insolvency. The answer is yes and no, depending upon the bank’s objective function and market structure. This paper differs from this literature in two ways. First, I am concerned with the probability of catastrophic failure, keeping the probability of insolvency fixed at a level determined by the regulators. Second, with the exception of Kahane (1977), banks are not able to short assets in these models. Shorting assets enables banks to create large left-tail loss distributions and is consistent with current banking practice. An essential element of our model structure is that we allow financial institutions to short risky assets.

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