Systemic Risk and Regulation∗
Franklin Allen
Department of Finance
Wharton School
University of Pennsylvania
Philadelphia, PA 19104 allenf@wharton.upenn.edu Douglas Gale
Department of Economics
New York University
269 Mercer Street
New York, NY 10003 douglas.gale@nyu.edu January 4, 2006

Abstract
Historically, much of the banking regulation that was put in place was designed to reduce systemic risk. In many countries capital regulation in the form of the Basel agreements is currently one of the most important measures to reduce systemic risk. In recent years there has been considerable growth in the transfer of credit risk across and between sectors of the financial system. In particular there is evidence that risk has been transfered from the banking sector to the insurance sector. One argument is that this is desirable and simply reflects diversification opportunities. Another is that it represents regulatory arbitrage and the concentration of risk that may result from this could
∗
We are grateful to our discussant Charles Calomiris and other participants at the
NBER Conference on "The Risks of Financial Institutions" held in Woodstock, Vermont,
October 22-23, 2004, our discussant Martin Hellwig and other participants at the CFS
Conference on "Risk Transfer between (Re-)Insurers, Banks, and Markets" held in Frankfurt, June 10-11, 2005, and our discussant Charles Kahn and other participants at the
Bank of Portugal Conference on "Financial Fragility and Bank Regulation" held in Lisbon, June 24-25, 2005. Finally, we also thank the editors, Mark Carey and Rene Stulz, for their very helpful comments on an earlier version and Florian Preis for pointing out an error in a previous version.

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increase systemic risk. This paper shows that both scenarios are possible depending on whether markets and contracts are complete or
incomplete.