Do Bank Risk Management and Regulatory Policy Reduce Risk in Banking?∗

This paper addresses the impact of dynamic risk management on bank risk taking. We show that when banks earn rents only from deposit insurance and can engage in risk management it is no longer in their interests to maximize risk; instead, they moderate their risk to increase their chances of survival. The paper also shows that the opportunity for risk management may change the impact of capital requirements on bank risk taking. In particular, with risk management, the introduction of capital requirements may increase the probability of default. When banks also earn rents from their assets more “prudent” capital requirements may increase both the probability of default and the value of the liabilities of the deposit insurer. JEL Classification: G21, G28