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Active Risk Management and Banking Stability

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  • Silva Buston, C.F.

    (Tilburg University, Center for Economic Research)

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    Abstract

    Abstract: This paper analyzes the net impact of two opposing eff ects 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 fi nd that active risk management banks were less likely to become insolvent during the crisis of 2007-2009, even though their balance sheets displayed higher risktaking. These results provide an important message for bank regulation, which has mainly focused on balance-sheet risks when assessing fi nancial stability.

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    Bibliographic Info

    Paper provided by Tilburg University, Center for Economic Research in its series Discussion Paper with number 2013-068.

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    Date of creation: 2013
    Date of revision:
    Handle: RePEc:dgr:kubcen:2013068

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    Web page: http://center.uvt.nl

    Related research

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

    This paper has been announced in the following NEP Reports:

    References

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    19. Goderis, B.V.G. & Marsh, I. & Vall Castello, J. & Wagner, W.B., 2006. "Bank Behavior with Access to Credit Risk Transfer Markets," Discussion Paper 2006-100, Tilburg University, Center for Economic Research.
    20. Alan Morrison, 2000. "Credit Derivatives, Disintermediation and Investment Decisions," OFRC Working Papers Series 2001fe01, Oxford Financial Research Centre.
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