Hedging and Coordinated Risk Management: Evidence from Thrift Conversions

TLDR

When increasing total risk is costly, firms optimally allocate risk by reducing exposure to zero‑rent risks and increasing exposure to positive‑rent risks. The study explains hedging as a tool for allocating rather than reducing risk. The conversion increases risk by hedging interest‑rate risk and taking on more credit risk. Conversion to stock institutions raises total risk, and risk‑management activities are linked to growth capacity and management compensation structures.

Abstract

ABSTRACT We provide an explanation for hedging as a means of allocating rather than reducing risk. We argue that when increases in total risk are costly, firms optimally allocate risk by reducing (increasing) exposure to risks that provide zero (positive) economic rents. Our evidence shows that mutual thrifts that convert to stock institutions increase total risk following conversion, consistent with their increased abilities and incentives for risk taking. They achieve this increase by hedging interest‐rate risk and increasing credit risk. We provide some evidence that risk‐management activities are related to growth capacity and management compensation structure attained at conversion.