Fuelling fire sales? Prudential regulation and crises: evidence from the Italian market

The ECB announcement to reduce capital requirements for market risk to smooth pro-cyclicality, published in April 2020, is a good starting point to discuss the impact of regulation on individual banks on the stability of the whole banking and financial system.

A large number of theoretical articles and a few empirical papers back the existence of an amplification effect on market volatility caused by the use of risk management measures (e.g. value-at-risk, VaR, for market risk) for regulatory purposes. However, to the best of my knowledge, no paper has empirically investigated the direct relation between the level of tightness of VaR risk limits and market volatility.

In this article, I show that market volatility is positively related to past values of the measure of the tightness of the market risk limit, with an overshooting process of adjustment toward equilibrium. The analysis is limited to Italy. The empirical results, based on a unique dataset of VaR values and on other publicly available market data, are in line with the theoretical findings and are novel empirical evidence. They open the way to additional research on how to manage the channels of transmission of the amplification and overshooting effects from the risk management measure to systemic variables, to avoid unintended consequences of the application of individual supervision measures on the whole system.