Dynamic Loss Probabilities and Implications for Financial Regulation

Much offinancial regulation and supervision is devoted to ensuring the safety and soundness of financial institutions. Such microand macroprudential policies are almost always formulated as capital requirements, leverage constraints, and other statutory restrictions designed to limit the probability of extreme financial loss to some small but acceptable threshold. However, if the risks of a financial institution's assets vary over time and across circumstances, then the efficacy of financial regulations necessarily varies in lockstep unless the regulations are adaptive. We illustrate this principle with empirical examples drawn from thefinancial industry, and show how the interaction of certain regulations with dynamic loss probabilities can have the unintended consequence of amplifying financial losses. We propose an ambitious research agenda in which legal scholars and financial economists collaborate to develop optimally adaptive regulations that anticipate the endogeneity ofrisk-taking behavior.