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Fat Tails and their (Un)happy Endings: Correlation Bias and its Implications for Systemic Risk and Prudential Regulation (Chan-Lau J. A.)

Basel I-III Corporate Governance in Banking Regulation Risk-taking and Risk Management

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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Libref/ Chan-Lau J. A. (2011) "Fat Tails and their (Un)happy Endings: Correlation Bias and its Implications for Systemic Risk and Prudential Regulation", IMF Working Paper No. 11/82, pp. 1 - 21
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