The impact of imposing capital requirements on systemic risk

• We build a static model on financial institutions’ risk-taking behavior.
• We quantify the impact of imposing capital requirements on systemic risk.
• Imposing capital requirements will enhance the systemic linkage within the system.
• The systemic risk on the cross-sectional dimension in a regulated system can be higher.
• A macro-prudential framework is necessary for maintaining financial stability.

This paper examines the impact of imposing capital requirements on systemic risk. We use a static model on financial institutions’ risk-taking behavior to quantify the systemic risk in the cross-sectional dimension in both regulated and unregulated systems. Although imposing a capital requirement can lower individual risk, it simultaneously enhances systemic linkage within the system. By using a proper systemic risk measure combining both individual risk and systemic linkage, we show that systemic risk in a regulated system can be higher than that in an unregulated system. In addition, we analyze a sufficient condition under which the systemic risk in a regulated system is always lower.