Competition Theory of Risk Management Failures
63 Pages Posted: 6 Jun 2015 Last revised: 10 Jul 2019
Date Written: August 1, 2017
We study a model in which firms compete preemptively for trading opportunities and risk management introduces latency in trading. As the time pressure faced by firms is endogenous to risk management choices, strategic complementarities can trigger a “race to the bottom” where prioritizing trade execution over risk management is individually optimal, but collectively inefficient. This generates an inverse relationship between trading volume/immediacy and efficiency of risk allocation. Different from theories where financing frictions or risk shifting cause a lack of risk management, ours predicts the pathology of risk management failures to be the trifecta of (1) “boom” markets, (2) time-based competition, and (3) firms in which risk assessment is time-consuming. We discuss merits and drawbacks of taxation, fines, and market design as possible countermeasures.
Keywords: Banks, Risk Management, Time Pressure, Coordination Failure, Global Games
JEL Classification: G20, G21, G28
Suggested Citation: Suggested Citation