Carrying the (paper) burden: A portfolio view of systemic risk and optimal bank size

In this paper we propose a two-level portfolio allocation optimization program and use it to explore the banking industry systemic risk management from a regulatory (supervisor) perspective. In our model banks choose their portfolio to maximize their own profits, while the supervisor optimizes the risk and return in the banking system as a whole. This may induce inefficiencies, leading to a banking system that produces excessive risk. We propose three policy scenarios based on current regulation practices and proposals and explore the ability of these regulatory regimes to reduce the systemic risk of the banking industry. We illustrate the use of the model by looking at over 9,000 US banks in the period 1984-2013, covering two major recessions. While all policy scenarios yield a better risk-return trade-off compared with the observed portfolio, the greatest improvements are achieved when the supervisor is able to limit the size of banks.