In this study, the mean–variance framework is employed to analyze the impact of the Basel value-at-risk (VaR) market risk regulation on the institution's optimal investment policy, the stockholders’ welfare, as well as the tendency of the institution to change the risk profile of the held portfolio. It is shown that with the VaR regulation, the institution faces a new regulated capital market line, which induces resource allocation distortion in the economy. Surprisingly, only when a riskless asset is available does VaR regulation induce the institution to reduce risk. Otherwise, the regulation may induce higher risk, accompanied by asset allocation distortion. On the positive side, the regulation implies an upper bound on the risk the institution takes and it never induces the firm to select an inefficient portfolio. Moreover, when the riskless asset is available, tightening the regulation always increases the amount of maintained eligible capital and decreases risk.
|Number of pages||27|
|Journal||European Journal of Finance|
|State||Published - 19 Feb 2015|
Bibliographical noteFunding Information:
We are grateful to two anonymous Referees and the Associate Editor for their helpful suggestions that helped improved the paper. We acknowledge financial support from the Krueger Center of Finance.
© 2013 Taylor & Francis.
- Basel regulations
- capital requirement regulation
- regulated capital market line
- risk management