Risk Management in Financial Institutions

We study risk management in financial institutions using data on hedging of interest rate risk by banks and bank holding companies. We find strong evidence that better capitalized institutions hedge more both in the cross-section and within institutions over time. For identification, we exploit net worth shocks resulting from loan losses due to drops in house prices. Institutions that sustain such losses reduce hedging substantially relative to otherwise similar institutions. The evidence is consistent with the theory that financial constraints impede both financing and hedging. We find no evidence that risk shifting, adjustments of interest rate risk exposures, or regulatory capital explain hedging behavior.

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