Regulatory Cliff Effects and Systemic Risk

Abstract

We identify systemic risks arising from regulatory cliff effects. Regulatory cliff effects lead to sudden discrete changes to asset properties, causing financial agents to act simultaneously in a homogeneous way, exacerbating systemic risk. We develop a model which quantifies these effects, and find that under certain circumstances, even small changes have drastic consequences. Taking the model to the data, we find that current market measures imply that the circumstances are satisfied for the Danish financial system. The model thus sheds light on the consequences of the regulation implemented since the Great Recession, given scenarios not yet empirically observable.

Keywords: Basel Accords, Reserve Requirements, Financial Crisis, Covered Bonds, Fire Sales

JEL Classification: G28, G21