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What Happens When You Regulate Risk? Evidence from a Simple Equilibrium Model

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  • Jean-Pierre Zigrand

    ()

  • Jon Danielsson

    ()

Abstract

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.

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File URL: http://www.lse.ac.uk/fmg/workingPapers/discussionPapers/fmg_pdfs/dp393.pdf
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Bibliographic Info

Paper provided by Financial Markets Group in its series FMG Discussion Papers with number dp393.

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Date of creation: Oct 2001
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Handle: RePEc:fmg:fmgdps:dp393

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Web page: http://www.lse.ac.uk/fmg/

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Cited by:
  1. Jean-Pierre Zigrand & Jon Danielsson, 2003. "On time-scaling of risk and the square–root–of–time rule," FMG Discussion Papers dp439, Financial Markets Group.
  2. Bühler, Wolfgang & Koziol, Christian, 2004. "Banking Regulation and Financial Accelerators: A One-Period Model with Unlimited Liability," Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems 17, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich.
  3. Dimitri Vayanos, 2004. "Flight to Quality, Flight to Liquidity, and the Pricing of Risk," NBER Working Papers 10327, National Bureau of Economic Research, Inc.
  4. Bernd Hofmann, 2005. "Procyclicality: The Macroeconomic Impact of Risk-Based Capital Requirements," Financial Markets and Portfolio Management, Springer, vol. 19(2), pages 179-200, August.
  5. Cornelis A. Los & Rossitsa M. Yalamova, 2004. "Multi-Fractal Spectral Analysis of the 1987 Stock Market Crash," Finance 0409050, EconWPA.
  6. Edgardo Barandiarán, 2003. "El Prestamista de Última Instancia en la Nueva Industria Bancaria," Latin American Journal of Economics-formerly Cuadernos de Economía, Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 40(120), pages 337-358.

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