Prudential regulation: is there a danger in reducing the volatility?

Submitted on 7th September 2017

Prudential regulations adopted in response to recent crises aim to reduce risks faced by financial institutions. Nevertheless, the feelings of a large number of practitioners are mixed: if these rules seem to succeed in lowering volatility, they appear to rigidify the financial structure of the economic system and, consequently, tend to increase the probability of large jumps. In other words, the volatility risk seemed to be swapped for a jump risk, producing a negative spillover, in the sense that the aimed reduction of volatility is accompanied by the increase of the intensity of jumps. Hence, the new rules of regulators seem to create a new risk. This paper discusses this idea in three ways. First, we introduce a conventionalist framework to be able to enter the puzzle of the swap. We define two conventions of quantification for the risk metrology, which allow us to introduce the risk swap effect. Second, we define precisely the two kinds of risk (volatility and intensity of jumps) and use them to document this risk swap effect by analysing a daily time series of the S&P500. We find that the recent evolution of the index indicates simultaneously a reduction in the volatility and an increase of the intensity of jumps, a result that validates the intuition of practitioners. Third, we analyse a model which allows one to appreciate a practical consequence of this swap of risks on the risk measures: using α-stable motions, we find that, for a given level of Value-at-Risk (VaR), the Tail Conditional Expectation (TCE) increases with the risk swap. We conclude by challenging the main objective of regulators: we argue that concentrating on reducing the sole volatility can create a new type of risk, that we term regulation risk, which increases the potential losses. This risk can be revealed with a con- ventionalist approach of quantification.

Actuaries Institute (Aus)
Length of Resource
21 pages
Jacques Levy Vehel, Christian Walter
Date Published
Publication Type
Resource Type