Recent developments vividly illustrate the importance of financial markets and financial institutions to a well-functioning modern economy. A seemingly small disruption in the sub-prime mortgage market has spread out to other financial markets and led to a severe crisis in the banking sector. Moreover, even the real sector of the economy is heavily impacted. A central part of financial institutions, the banking sector, is heavily regulated and interventions in the banking sector undoubtedly have an impact on the economy far beyond the regulated banking institution or even the banking sector itself. Thus, the central question arises of whether regulation indeed supports financial stability or not. The building block of the current banking regulation are risk-sensitive capital requirements, which are based upon the Value-at-Risk (VaR) as a measure for risk. This measure can be easily understood and it is proposed by many institutions such as the Basle Committee on Banking Supervision, the SEC, the G30, the ISDA, and the Derivatives Group. Moreover, it is implemented by risk management systems such as RiskMetrics and it is widely accepted in the industry. In this thesis we do not question whether banks should be regulated or not nor whether VaR is the optimal choice for a risk measure to base regulation on. Instead, we take the common banking regulation with VaR based capital requirements as given and analyze the impact of regulation on the stability of the banking sector.
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