What Happens When You Regulate Risk? Evidence from a Simple Equilibrium Model
London School of Economics - Department of Accounting and Finance
London School of Economics - Department of Finance and Financial Markets Group
The implications of Value-at-Risk regulations are analyzed in a CARA--normal general equilibrium model. Financial institutions are heterogeneous in risk preferences, wealth and the degree of supervision. Regulatory risk constraints lower the probability of one form of a systemic crisis, at the expense of more volatile asset prices, less liquidity, and the amplification of downward price movements. This can be viewed as a consequence of the endogenously changing risk appetite of financial institutions induced by the regulatory constraints. Finally, the Value-at-Risk constraints may prevent market clearing altogether. The role of unregulated institutions (hedge-funds) is considered. The findings are illustrated with an application to the 1987 and 1998 crises.
Number of Pages in PDF File: 42
Keywords: General equilibrium; Value-at-risk; Risk regulation
JEL Classification: G12, G18, G20, D50working papers series
Date posted: November 13, 2001
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