How Theories of Financial Intermediation and Corporate Risk‐Management Influence Bank Risk‐Taking Behavior

Abstract

This paper examines the rationales for risk‐taking and risk‐management behavior from both a corporate finance and a banking perspective. After combining the theoretical insights from the corporate finance and banking literatures related to hedging and risk‐taking, the paper reviews empirical tests based on these theories to determine which of these theories are best supported by the data. Managerial incentives are the most consistently supported rationale for describing how banks manage risk. In particular, moderate/high levels of equity ownership reduce bank risk while positive amounts of stock option grants increase bank risk‐taking behavior. The review of empirical tests in the banking literature also suggests that financial intermediaries coordinate different aspects of risk (e.g., credit and interest rate risk) in order to maintain a certain level of total risk. The empirical results indicate hedgeable risks such as interest rate risk represent only one dimension of the risk‐management problem. This implies empirical tests of the theories of corporate risk‐management need to consider individual sub‐components of total risk and the bank’s ability to trade these risks in a competitive financial market. This finding is consistent with the reality that banks have non‐zero expected financial distress costs and bank managers cannot fully diversify their bank‐related personal investments.