Competition Theory of Risk Management Failures
57 Pages Posted: 6 Jun 2015 Last revised: 16 Jun 2019
Date Written: August 2017
We model risk management as information acquisition that creates latency for trading firms engaged in preemptive competition. Since time pressure is endogenous to risk management decisions, strategic complementarities sustain a ``race to the bottom" where prioritizing trade execution over risk management is optimal for each firm, but collectively inefficient. As time competition intensifies, mean trading profitability supplants higher-order risk moments in risk management decisions, causing misallocation of risks to increase together with trading volume and immediacy. This pathology of risk management failures -the trio of boom markets, preemptive competition, and time-consuming risk assessments- has distinct regulatory implications.
Keywords: Banks, Risk Management, Time Pressure, Coordination Failure, Global Games
JEL Classification: G20, G21, G28
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