Risk management strategies for banks

Abstract We analyze optimal risk management strategies of a bank financed with deposits and equity in a one period model. The bank’s motivation for risk management comes from deposits which can lead to bank runs. In the event of such a run, liquidation costs arise. The hedging strategy that maximizes the value of equity is derived. We identify conditions under which well known results such as complete hedging, maximal speculation or irrelevance of the hedging decision are obtained. The initial debt ratio, the size of the liquidation costs, regulatory restrictions, the volatility of the risky asset and the spread between the riskless interest rate and the deposit rate are shown to be the important parameters that drive the bank’s hedging decision. We further extend this basic model to include counterparty risk constraints on the forward contract used for hedging.

[1]  René M. Stulz,et al.  The Determinants of Firms' Hedging Policies , 1985, Journal of Financial and Quantitative Analysis.

[2]  D. Hester.  On the theory of financial intermediation , 1994 .

[3]  M. C. Jensen,et al.  Harvard Business School; SSRN; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI); Harvard University - Accounting & Control Unit , 1976 .

[4]  A. Thakor,et al.  Contemporary Banking Theory , 1993 .

[5]  Douglas W. Diamond.  Financial Intermediation and Delegated Monitoring , 1984 .

[6]  R. C. Merton,et al.  Financial Innovation and the Management and Regulation of Financial Institutions , 1995 .

[7]  E. Baltensperger,et al.  Theorie des Bankverhaltens , 1987 .

[8]  Sudipto Bhattacharya,et al.  Distinguishing Panics and Information-based Bank Runs: Welfare and Policy Implications , 1988, Journal of Political Economy.

[9]  Raghuram G. Rajan,et al.  Banks as Liquidity Providers: An Explanation for the Coexistence of Lending and Deposit‐taking , 2002 .

[10]  Douglas W. Diamond,et al.  A Theory of Bank Capital , 1999 .

[11]  Kenneth A. Froot,et al.  Risk Management, Capital Budgeting and Capital Structure Policy for Financial Institutions: An Integrated Approach , 1996 .

[12]  Peter M. DeMarzo,et al.  Corporate Incentives for Hedging and Hedge Accounting , 1995 .

[13]  R. E. Shrieves,et al.  The relationship between risk and capital in commercial banks , 1992 .

[14]  Merton H. Miller.  The Cost of Capital, Corporation Finance and the Theory of Investment , 1958 .

[15]  René M. Stulz,et al.  Rethinking Risk Management , 1996, Journal of Applied Corporate Finance.

[16]  F. Black,et al.  The Pricing of Options and Corporate Liabilities , 1973, Journal of Political Economy.

[17]  Joel M. Stern,et al.  The Revolution in Corporate Finance , 1992 .

[18]  Catherine M. Schrand,et al.  Hedging and Coordinated Risk Management: Evidence from Thrift Conversions , 1998 .

[19]  A. Mozumdar.  Corporate Hedging and Speculative Incentives: Implications for Swap Market Default Risk , 2001, Journal of Financial and Quantitative Analysis.

[20]  Ilya Segal,et al.  Solutions manual for Microeconomic theory : Mas-Colell, Whinston and Green , 1997 .

[21]  Bank Risk Management and the Franchise Value , 2004 .

[22]  Christopher M. James,et al.  The Losses Realized in Bank Failures , 1991 .

[23]  Franklin Allen,et al.  What do financial intermediaries do , 2001 .

[24]  Arnoud Boot.  Relationship Banking: What Do We Know? , 2000 .

[25]  Kenneth A. Froot,et al.  Risk Management: Coordinating Corporate Investment and Financing Policies , 1992 .

[26]  Douglas W. Diamond,et al.  Financial Intermediation as Delegated Monitoring: A Simple Example , 1996 .

[27]  Raghuram G. Rajan,et al.  Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of Banking , 1999, Journal of Political Economy.

[28]  Paul E. Fischer,et al.  Hedging and Coordinated Risk Management : Evidence from Thrift Conversion 1 First Draft : May 1995 Current Draft : December 1995 , 1996 .

[29]  Philip H. Dybvig,et al.  Bank Runs, Deposit Insurance, and Liquidity , 1983, Journal of Political Economy.

[30]  H. Leland..  Agency Costs, Risk Management, and Capital Structure , 1998 .