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Dynamic volatility regulation of financial institutions

Author

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  • Hilscher, Jens
  • Raviv, Alon
  • Wiener, Zvi

Abstract

Unlike non-financial firms, financial institutions are often heavily regulated to prevent bankruptcies and negative spillovers. A main regulatory tool is risk-based capital requirements. To reflect this reality, we develop a model that allows for dynamically updated asset risk, in contrast to standard contingent claim models that assume constant volatility. Regulators impose a decrease in asset volatility when the capital cushion becomes small, thereby reducing the risk of distress. We show that such regulation of financial institutions affects their credit spreads, credit ratings, transition matrices, valuation of liabilities, cost of deposit insurance, and risk-shifting incentives.

Suggested Citation

  • Hilscher, Jens & Raviv, Alon & Wiener, Zvi, 2024. "Dynamic volatility regulation of financial institutions," Finance Research Letters, Elsevier, vol. 61(C).
    • Handle: RePEc:eee:finlet:v:61:y:2024:i:c:s1544612323013405
    DOI: 10.1016/j.frl.2023.104968
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