Tight banking rules meant to stop crashes are actually making the whole financial system more unstable.
March 24, 2026
Original Paper
Macroprudential Policy, Balance Sheets, and Tail Risk
SSRN · 6397098
The Takeaway
While strict risk constraints reduce the frequency of rare 'tail risk' events, they force banks to engage in massive sell-offs the moment things go wrong. This magnifying effect makes the day-to-day economy more unstable and causes recessions to last significantly longer than they otherwise would.
From the abstract
This paper develops a continuous-time general equilibrium model in which risk-tolerant financial intermediaries borrow from risk-averse households to hold levered positions in productive capital, subject to Value-at-Risk (VaR) constraints on their risk exposure. Adverse aggregate shocks erode intermediary capital and depress asset prices and investment through a balance sheet channel-precisely the conditions under which VaR constraints bind, triggering forced deleveraging that amplifies these ef