Active Risk Management and Banking Stability

C.F. Silva Buston

Research output: Working paperDiscussion paperOther research output

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Abstract

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 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.
Original languageEnglish
Place of PublicationTilburg
PublisherEconomics
Number of pages44
Volume2013-068
Publication statusPublished - 2013

Publication series

NameCentER Discussion Paper
Volume2013-068

Fingerprint

Risk management
Banking
Balance sheet
Isolation
Portfolio risk
Anticipation
Prediction
Bank holding companies
Empirical evidence
Incentives
Bank regulation
Credit supply
Risk taking
Insolvency
Credit
Economic conditions

Keywords

  • Financial innovation
  • credit derivatives
  • financial stability
  • financial crisis

Cite this

Silva Buston, C. F. (2013). Active Risk Management and Banking Stability. (CentER Discussion Paper; Vol. 2013-068). Tilburg: Economics.
Silva Buston, C.F. / Active Risk Management and Banking Stability. Tilburg : Economics, 2013. (CentER Discussion Paper).
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Silva Buston, CF 2013 'Active Risk Management and Banking Stability' CentER Discussion Paper, vol. 2013-068, Economics, Tilburg.

Active Risk Management and Banking Stability. / Silva Buston, C.F.

Tilburg : Economics, 2013. (CentER Discussion Paper; Vol. 2013-068).

Research output: Working paperDiscussion paperOther research output

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T1 - Active Risk Management and Banking Stability

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N1 - Pagination: 44

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N2 - 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 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.

AB - 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 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.

KW - Financial innovation

KW - credit derivatives

KW - financial stability

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Silva Buston CF. Active Risk Management and Banking Stability. Tilburg: Economics. 2013. (CentER Discussion Paper).