Risk Management Failures

Abstract

We present a theory in which deficiencies in risk management arise from a coordination failure. Firms choose privately optimal risk management regimes to be competitive in a market with shortlived trading opportunities, but the aggregate outcome can be a constrained inefficient “race to the bottom,” with the firms’ best responses to time pressure exhibiting strategic complementarities reminiscent of bank runs. Comparative statics based on global games suggest that greater market access or faster search (or trading) technologies may improve certain measures of liquidity but at the same time generate excessive trading that undermines allocative efficiency. We identify two sources of market failure operating through opportunity costs and agency rents, and discuss two regulatory approaches that view lack of risk management as a governance problem or as a public goods problem.