Bank fragility and risk management
Shocks to a bank’s ability to raise liquidity at short notice can trigger depositor panics. Why don’t banks take a more active role in managing these risks? We study contingent risk management (hedging) in a standard global-games model of a bank run. Banks fail to hedge precisely when the exposure to a shock is most severe, just when risk management would have the biggest impact. Higher bank capital and broader deposit-insurance coverage crowd out hedging by banks that already manage risk, yet encourage more banks to establish risk management desks in the first place.