Any regulation of risk increases risk
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We show that any objective risk measurement algorithm mandated by central banks for regulated financial entities will result in more risk being taken by those financial entities than would otherwise be the case. Furthermore, the risks taken by the regulated financial entities are far more systemically concentrated than they would have been otherwise, making the entire financial system more fragile. This result leaves three options for the future of financial regulation: (1) continue regulating by enforcing risk measurement algorithms at the cost of occasional severe crises, (2) regulate more severely and subjectively by fully nationalizing all financial entities, or (3) abolish all central banking regulations, including deposit insurance, thus allowing risk to be determined by the entities themselves and, ultimately, by their depositors through voluntary market transactions, rather than by the taxpayers through enforced government participation.
KeywordsRegulation Crisis Risk management Value-at-risk Risk Basel
JEL ClassificationG18 G21 G28 G38
The authors are grateful for comments and suggestions by the anonymous referee, Darrell Duffie, David R. Henderson, participants at the Stanford University Workshop on Capitalism’s Crises, the Society of Actuaries conference, and a research presentation at Oliver Wyman.
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