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

  • Jean-Pierre Zigrand

    ()

  • Jon Danielsson

    ()

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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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
Contact details of provider: Web page: http://www.lse.ac.uk/fmg/

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