Regulation, Financial Networks, and Systemic Risks

This paper builds a model of a regulation game, in which the active regulator moves first and designs the regulation requirement with the consideration of the network formed by banks and the associated systemic risk. Banks form the network strategically and diversify their portfolios within the network in response to the regulation. Multiple equilibrium network structures are fully characterized and ranked with the possibility of independent negative shocks to each bank. We show that the equilibrium strategy for banks is to form the most-risky network structure if the regulation is tighter than a threshold and form the least-risky network structure if the regulation is looser than the threshold. To prevent the most-risky network to be formed, the regulator imposes a capital requirement level at the threshold, which is suboptimal because it is looser than the socially optimal one