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What happens when you regulate risk?: evidence from a simple equilibrium model

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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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en

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application/pdf

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http://eprints.lse.ac.uk/25069/1/dp393.pdf

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