Regulation Risk

Abstract

Market risk regulations adopted in response to recent crises aim to reduce financial risks. Nevertheless, a large number of practitioners feel that even, if these rules seem to succeed in lowering volatility, they appear to rigidify the financial structure of the economic system and tend to increase the probability of large jumps: prudential rules seem to produce an unexpected effect, the swap between volatility risk and jump risk. The attempt at reduction in volatility is accompanied by an increase in the intensity of jumps. The new regulations seem create a new risk. This article discusses this idea in three ways. First, we introduce a conventionalist framework to shed some light on this unexpected effect. Second, we precisely define volatility risk and the intensity of jumps to document the risk swap effect by analyzing a daily time series of the S&P 500. Third, we propose a model that allows one to appreciate a practical consequence of this swap on the risk measures. We conclude by challenging the main objective of regulation: we argue that concentrating on reducing volatility can create a new type of risk that increases the potential losses, which we term regulation risk.

ACKNOWLEDGMENTS

The source of inspiration for this article came from an idea offered by Hubert Rodarie. This idea was next discussed with Philippe Desurmont, head of the Asset Management Department of SMA, for the investment point of view. Earlier drafts of this article were presented to audiences at several seminars and conferences (Actuarial Research Conference, Santa Barbara, 2014; AFIR Colloquium, Sydney, 2015; Quantitative Methods of Finance Conference, Sydney, 2016). We thank the participants for their helpful and valuable comments and discussions. Olivier Le Courtois thanks Xia Xu for building up the database used in the empirical part of the article. Christian Walter thanks Eve Chiapello for stimulating and challenging discussions for the sociological part of the article. This work was conducted with the SMA Actuarial R&D Program. We thank the actuaries of the company, Mohamed Majri, Anthony Floryszczak, François-Xavier de Lauzon, and Jérémy Allali, for their useful comments on earlier versions of this article. The authors thank two anonymous referees whose comments helped to greatly improve this article.

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Notes

1 The assumption of constant VaR is justified by the fact that the regulator imposes solvency capital requirements that are increasing functions of VaR. In order to maintain these requirements at a reasonable level, companies wish to control their VaR as much as possible.

2 Note that the danger of such a reduction has been emphasized rather early and has been studied in a stream of research that tries to evaluate volatility risk models. For instance, the fact that volatility alone is not sufficient for characterizing the dynamics of returns and how it may be complemented is analyzed in Gouriéroux and Le Fol (1997) and Alami and Renault (2000).