Risk Management Under a Prudential Policy

Abstract

In this paper, we study the structure of optimal contracts in a banking system when there is no risk of moral hazard. We consider a risk management problem under a policy that reduces the excessive risk taking behavior by making all banks bear part of the risk that they transfer to other parties in the market. First, we characterize the optimal solutions to the risk management problem, and, second, we find a necessary and sufficient condition under which the “risk of the tail events” will not be transferred. In particular, we will study the problem using two known risk measures, Value at Risk and Conditional Value at Risk, and will show that in these cases the optimal solutions are in the form of stop-loss policies.