Active Risk Management and Banking Stability

Abstract

This paper analyzes the net impact of two opposing effects of active risk management at banks on their stability: higher risk-taking incentives and better isolation of credit supply from varying economic conditions. We present a model where banks actively manage their portfolio risk by buying and selling credit protection. We show that anticipation of future risk management opportunities allows banks to operate with riskier balance sheets. However, since they are better insulated from shocks than banks without active risk management, they are less prone to insolvency. Empirical evidence from US bank holding companies broadly supports the theoretical predictions. In particular, we find that active risk management banks were less likely to become insolvent during the crisis of 2007-2009, even though their balance sheets displayed higher risk-taking. These results provide an important message for bank regulation, which has mainly focused on balance-sheet risks when assessing financial stability.

Keywords: Financial innovation, credit derivatives, financial stability, financial crisis