Accounting for Strategic Response in an Agent-Based Model of Financial Regulation

Abstract

Due to complex interactions in financial markets, financial regulations can sometimes produce unexpected outcomes, and fail to achieve their macroeconomic goals. We replicate a previous agent-based simulation study which showed that the Basel banking regulations may increase financial instability, counter to their intended purpose. Our replication confirms that this is the case, following the original study's assumption that the financial firms' behaviors are fixed. We then extend the model to account for a possible strategic response, where financial firms adapt to the regulatory regime. Using empirical game-theoretic analysis, we derive equilibria with and without regulation. We find that in the new Basel-regulated equilibria, more funds stay out of default and banks lose less capital. The overall effect of regulation on financial stability becomes benign on most measures when accounting for the strategic adaptation of agents.