ERM: Law of Unintended Consequences [2]

From Neil Bodoff

One of the reasons that so many counterparties bought CDS protection [from the same counterparty, precipitating a crisis] was their desire to reduce their regulatory capital requirements. So the regulatory framework had high capital requirements for credit risk, but low capital requirements when the credit risk was hedged. Basically the regulatory framework created a strong incentive for all banks to simultaneously execute the same strategy of hedging risk via CDS. Lessons are: [1] Whereas individual firms in a competitive market may pursue various strategies, the government’s monopoly on regulation might create a homogenizing effect on firms’ behavior, thus concentrating risk. Thus the regulatory framework itself becomes a systemic risk and thus requires extra scrutiny and care. [2] For any regulatory framework, the designers ought to choose someone to “roleplay” the part of firms trying to minimize regulatory capital requirements, so as to understand the behaviors and countermeasures the firms might take in response to the regulatory demands. [3] Beware of unintended consequences.

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Explore posts in the same categories: Counterparty Risk, Financial Crisis, Hedging, Regulatory Risk, Risk, risk transfer

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One Comment on “ERM: Law of Unintended Consequences [2]”

  1. JimmyBean Says:

    I don’t know If I said it already but …Cool site, love the info. I do a lot of research online on a daily basis and for the most part, people lack substance but, I just wanted to make a quick comment to say I’m glad I found your blog. Thanks, 🙂

    A definite great read..Jim Bean


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