Dynamic volatility regulation of financial institutions

Jens Hilscher, Alon Raviv and Zvi Wiener

Finance Research Letters, 2024, vol. 61, issue C

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.

Keywords: Asset risk; Dynamic volatility; Banks; Regulator; Leverage; Deposit insurance; Credit spread; Stress test; Financial crisis; Basel II (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:eee:finlet:v:61:y:2024:i:c:s1544612323013405

DOI: 10.1016/j.frl.2023.104968

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