Incentives for Effective Risk Management

Under the new Capital Accord, banks choose between two different types of risk management systems, the standard or the internal rating based approach. The paper considers how a bank's preference for a risk management system is affected by the presence of supervision by bank regulators. The model uses a principal–agent setting between a bank's owner and its risk management. The main conclusion is that previously unregulated institutions can be expected to switch to the lower quality standard approach subsequent to becoming regulated, i.e., the presence of regulation may induce a bank to decrease the quality of its risk management system. Published in Journal of Banking and Finance (2002) 26, 1407-25.Risk management systems; Regulation; Value-at-Risk; Basel-II

Optimal Portfolio Allocation under a Probabilistic Risk Constraint and the Incentives for Financial Innovation

We characterize the investor’s optimal portfolio allocation subject to a budget constraint and a probabilistic VaR constraint in complete markets environments with a finite number of states. The set of feasible portfolios might no longer be connected or convex, while the number of local optima increases exponentially with the number of states, implying computational complexity. The optimal constrained portfolio allocation may therefore not be monotonic in the state–price density. We propose a type of financial innovation, which splits states of nature, that is shown to weakly enhance welfare, restore monotonicity of the optimal portfolio allocation in the state-price density, and reduce computational complexity. This discussion paper resulted in a publication in Annals of Finance , 2008, 4(3), 345-67.Portfolio Optimization; Value-at-Risk; NP-hard