The Dynamics of Financial Stability (Cruz J. P., Lind P. G.)

Basel I-III Regulation Stability&Soundness

Abstract The social role of any company is to get the maximum profitability with the less risk. Due to Basel III, banks should now raise their minimum capital levels on an individual basis, with the aim of lowering the probability for a large crash to occur. Such implementation assumes that with higher minimum capital levels it becomes more probable that the value of the assets drop bellow the minimum level and consequently expects the number of bank defaults to drop also. We present evidence that in such new financial reality large crashes are avoid only if one assumes that banks will accept quietly the drop of business levels, which is counter-nature. Our perspective steams from statistical physics and gives hints for improving bank system resilience. Stock markets exhibit critical behavior and scaling features, showing a power-law for the amplitude of financial crisis. By modeling a financial network where critical behavior naturally emerges it is possible to show that bank system resilience is not favored by raising the levels of capital. Due to the complex nature of the financial network, only the probability of bank default is affected and not the magnitude of a money market crisis. Further, assuming that banks will try to restore business levels, raising diversification and lowering their individual risk, the dimension of the entire financial network will increase, which has the natural consequence of raising the probability of large crisis.
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Libref/ Cruz J. P., Lind P. G. (2011) "The Dynamics of Financial Stability", pp. 1 - 7
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