What Happens When You Regulate Risk? Evidence from a Simple Equilibrium Model

Jon Danielsson and Jean-Pierre Zigrand
May 2003

Global financial regulations are increasingly becoming risk sensitive. The economic implications of such a system are analyzed in a general equilibrium model with agents that are heterogeneous in risk preferences, wealth, and degree of supervision. Excessive risk taking arises due to externalities, giving rise to systemic risk. The model suggests that risk sensitive regulation can lower systemic risk, at the expense of an increase in risk premia, higher asset volatility, lower liquidity, more comovement in prices, and the chance that markets may not clear. In some situations, however, systemic risk can be worsened by risk sensitive regulation.