Jon Danielsson, Hyun Song Shin, Jean-Pierre Zigrand, 11 March 2009

By incorporating endogenous risk into a standard asset-pricing model, this column shows how banks’ capacity to bear risk seemingly evaporates in the face of market turmoil, pushing the financial system further into a tailspin. It suggests that risk-sensitive prudential regulation, in the spirit of Basel II, makes systemic financial crises sharper, larger, and more costly.

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