In the aftermath of the financial crisis, there is interest in reforming bank regulation such
that capital requirements are more closely linked to a bank’s contribution to the overall risk
of the financial system. In our paper we compare alternative mechanisms for allocating
the overall risk of a banking system to its member banks. Overall risk is estimated using
a model that explicitly incorporates contagion externalities present in the financial system.
We have access to a unique data set of the Canadian banking system, which includes individual
banks’ risk exposures as well as detailed information on interbank linkages including
OTC derivatives. We find that macroprudential capital allocations can differ by as much as
50% from observed capital levels and are not trivially related to bank size or individual bank
default probability. Macroprudential capital allocation mechanisms reduce default probabilities
of individual banks as well as the probability of a systemic crisis by about 25%.
Our results suggest that financial stability can be enhanced substantially by implementing
a systemic perspective on bank regulation.