Dynamic volatility regulation of financial institutions

Jens Hilscher, Alon Raviv*, Zvi Wiener

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

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.

Original languageAmerican English
Article number104968
JournalFinance Research Letters
Volume61
DOIs
StatePublished - Mar 2024

Bibliographical note

Publisher Copyright:
© 2023

Keywords

  • Asset risk
  • Banks
  • Basel II
  • Credit spread
  • Deposit insurance
  • Dynamic volatility
  • Financial crisis
  • Leverage
  • Regulator
  • Stress test

Fingerprint

Dive into the research topics of 'Dynamic volatility regulation of financial institutions'. Together they form a unique fingerprint.

Cite this