Regulation Risk

Market risk regulations adopted in response to recent crises aim to reduce financial risks. Nevertheless, a large number of practitioners feel that, 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 aimed reduction of volatility is accompanied by an increase in the intensity of jumps. The new regulations seem create a new risk. This paper discusses this idea in three ways. First, we introduce a conventionalist framework to put some light on this unexpected effect. Second, we precisely define volatility risk and the intensity of jumps to document the risk swap effect by analysing a daily time series of the SP500 Index. Third, we propose a model which 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 the sole volatility can create a new type of risk which increases the potential losses, that we term regulation risk.