Any Regulation of Risk Increases Risk

TL;DR

Mandating objective risk measurement algorithms by central banks leads to increased risk-taking and systemic concentration among financial entities, ultimately making the financial system more fragile.

Contribution

The paper demonstrates that enforced risk measurement algorithms unintentionally increase risk and systemic fragility, challenging current regulatory approaches.

Findings

Risk measurement mandates increase overall risk.

Regulated risks are more systemically concentrated.

Financial system becomes more fragile under regulation.

Abstract

We show that any objective risk measurement algorithm mandated by central banks for regulated financial entities will result in more risk being taken on by those financial entities than would otherwise be the case. Furthermore, the risks taken on by the regulated financial entities are far more systemically concentrated than they would have been otherwise, making the entire financial system more fragile. This result leaves three directions for the future of financial regulation: continue regulating by enforcing risk measurement algorithms at the cost of occasional severe crises, regulate more severely and subjectively by fully nationalizing all financial entities, or abolish all central banking regulations including deposit insurance to let risk be determined by the entities themselves and, ultimately, by their depositors through voluntary market transactions rather than by the taxpayers through enforced government participation.