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Regulation Incentives for Risk Management in Incomplete Markets
Jon Danielsson, Casper de Vries and Bjorn Jorgensen
Implicit government guarantees induce moral hazard. The potential for moral hazard under the new Basel Capital Accord is explored with three different incomplete markets models. First, where investment decisions are affected by direct risk regulation causing more risky investments to be selected. Second, how risk regulation restricts banks' alternative (off--equilibrium) project selection. Third, principal--agent relationships between a bank's board and its risk manager. In all three cases the government intervention has the potential to increase unintended risk levels due to market incompleteness.