Risk Management, Financial Contagion, and Banking Regulation

Risk management is a central function of banks. Our model examines how banks use this ability to shift risk away from entrepreneurs. To create incentive compatibility, banks must assume some of the entrepreneurial risks, e. g. by underwriting OTC hedging contracts or granting loans. The arising bankruptcy risk causes potential contagion. A conflict of interest emerges because banks prefer a diversified customer portfolio, whereas customers attach more importance to getting adequate contracts from the bank. We show that this conflict cannot be overcome by contractual arrangements between customer and bank. Therefore, banking regulation is desirable to reduce welfare losses. We identify three fundamental instruments for regulation.