Dealing with systematic risk when we measure it badly

While an omniscient regulator would base a bank's capital requirement upon its contribution to systemic risk, we show that a regulator who measures a bank's contribution to systemic risk badly will find it optimal to use a simple leverage ratio instead. We empirically analyze the performance of leading risk measurement methods and find that they are incapable of providing either precise estimates of an individual bank's contribution to systemic risk or reliable rankings of banks by the amount of systemic risk they create. We conclude that a leverage ratio dominates a policy of systemic risk based capital requirements.