Social welfare analysis in a financial economy with risk regulation

Abstract

In the last years, regulating agencies of many countries in the world have adopted VaR-based risk regulation to control market risk of financial institutions. This paper investigates the consequences of such kind of regulation to social welfare and soundness of financial institutions through an equilibrium model. We show that the optimum level of regulation for each financial institution (the level that maximizes its utility) depends on its appetite for risk and that some of them can perform better in a regulated economy. In addition, another important result asserts that under certain market conditions the financial fragility of an institution can be greater in a regulated economy than in an unregulated one. © 2010 Wiley Periodicals, Inc.