Why firms manage risk · RiskAtoms Academy

By the end you will be able to

1Explain why banks and insurers manage risk rather than avoid it: stable earnings, solvency and the cost of distress.
2Explain why hedging would add no value in a perfect market, and which real-world frictions change that.
3Show, in a simple example, how hedging changes the chance and the cost of financial distress.
4Sort a firm's risks into those it should keep, hedge or transfer, and reduce.

Why it matters

A bank that took no risk would make no loans. An insurer that took no risk would sell no policies. Risk is their raw material. The question is never whether to take risk, but which risks, how much, and what to do with the rest.

Core explanation

Risk is the product, so it has to be managed

Recall the two business models from M1.2: Financial institutions. A bank borrows short from depositors and lends long to households and firms (L1.2.01: Commercial banks: the business model): it earns its margin by bearing credit risk and the risk of a maturity mismatch. An insurer collects premiums today and pays claims later (L1.2.03: Insurers: life and non-life): it earns by pooling insurance risk. Avoid those risks and the business disappears.

So these firms practise risk management: they decide which risks to take, how much of each they can carry (their risk appetite), and what to do with risks they do not want. Three reasons drive this.

Stable earnings

Predictable profits let a firm plan, invest and pay dividends without raising expensive new money at the worst moment.

Solvency

Capital must stay above the regulator's minimum. A firm that falls below it loses control of its own future.

The cost of distress

Long before it fails, a weakened firm loses customers, pays more to borrow and may have to sell assets cheaply.

The case against hedging, and why it fails

There is a strong argument that firms should not bother. In 1958 Franco Modigliani and Merton Miller showed that in a perfect market, with no taxes, no costs of distress and free trading, the way a firm is financed cannot change its value. The same logic applies to hedging: shareholders can diversify or hedge for themselves, so they gain nothing when the firm does it for them. This is the Modigliani and Miller starting point.

Real markets are not perfect, and the imperfections are exactly where risk management earns its keep. The biggest is the cost of financial distress, and it is especially large for banks and insurers, because their customers are also their creditors. Depositors are owed their deposits, policyholders their claims. When they doubt the firm, they leave. In March 2023 depositors tried to withdraw about US$42 billion from Silicon Valley Bank in a single day (L1.8.02: A bank’s balance sheet).

Think firstWhat does distress cost? Tap each

Other frictions point the same way: taxes that take a bigger bite from volatile profits than from steady ones, outside funding that is dearest when the firm is weakest, and managers and staff who cannot diversify away their own firm. Each makes stable earnings worth more than their average alone suggests.

Keep, hedge, or reduce

Managing risk does not mean removing it. A firm keeps its core risks, where it has skill and is paid, and manages them with pricing, limits and capital. It hedges or transfers side risks that it is not paid for. And it reduces risks that bring no reward at all, such as errors and fraud. M2.6: Hedging and mitigation covers the tools in detail.

Sort itKeep, hedge or reduce?

0 of 7 right

For each risk, what would a well-run firm usually do?

A bank's credit risk on loans to local small businesses it knows well.
A UK insurer's exposure to the dollar on US bonds it holds as investments.
A property insurer's exposure to one huge hurricane hitting a single region.
The risk that staff sell customers products that do not suit them.
A life insurer's risk on the annuities it sells: that customers live longer than expected.
A bank funds fixed-rate mortgages with deposits whose rates can change at any time.
The risk of a cyber attack stealing customer data.

Try it

An illustrative bank starts the year with €10bn of capital and must keep at least €8bn. Its earnings next year are one of five equally likely outcomes. Hedging part of the swing costs a little each year. Start with no hedge, then raise the hedge until no bar is red. Then set the distress cost to zero and see what changes.

Try itIs stability worth paying for?

How much earnings swing±€2.50bn a step

Share of the swing hedged0% (costs €0.00bn)

Extra cost of a year in distress€3.0bn

Capital at the end of each of five equally likely years. Below the dashed €8bn line the bank is in distress.

Average earnings€1.50bn

Worst year−€3.50bn

Years in distress1 of 5

Average distress cost€0.60bn

Average result€0.90bn

Gain from hedging€0.00bn

Try hedging until no bar is red.

Worked example

Paying for stability

The bank from the Try it, at its starting settings: earnings swing by ±€2.50bn a step around €1.50bn, a full hedge costs €0.20bn a year, and a year in distress costs a further €3bn. Amounts in € billions; illustrative.

Three choices

Step 1 of 5

1
No hedge
Earnings are −3.5, −1.0, 1.5, 4.0, 6.5: an average of €1.50bn. In the worst year capital falls to €6.5bn, below the minimum.

Regulatory lens

Regulators turn the cost of distress into hard rules. Banks must keep capital above minimum ratios under the Basel framework, with buffers on top that restrict dividends and bonuses when they are used. Under Solvency II, an insurer that falls below its Solvency Capital Requirement must agree a recovery plan with its supervisor, and one that falls below the lower Minimum Capital Requirement can lose its licence. L2.7.01: Why banks and insurers are regulated explains why these firms are regulated at all.

Firm	Main core risks	Who is hurt by distress
Bank	Credit, interest rate mismatch	Depositors, borrowers, the payment system
Insurer	Insurance (claims, longevity), investment	Policyholders, often decades later

Sparks

SparkTwo Nobel prizes for “it doesn't matter”

Franco Modigliani (1985) and Merton Miller (1990) both won the Nobel prize in economics, partly for showing when financing choices do not matter. Their result is most useful as a checklist: whenever risk management adds value, it is because one of their perfect-market assumptions fails.

SparkA hedge can sink you too

Hedging creates risks of its own. The oil hedge in L1.7.12: Derivatives disasters and their lessons was sound in value but drained cash through margin calls. Managing risk means understanding the hedge as well as the risk it covers.

Key takeaways

Banks and insurers earn by bearing risk, so they manage risk rather than avoid it.
Three reasons drive risk management: stable earnings, staying solvent, and avoiding the costs of distress.
In a perfect market hedging adds no value; it pays because distress is costly, taxes and outside funding bite, and customers are creditors.
Good risk management keeps core risks, hedges or transfers side risks, and reduces risks that bring no reward.
The aim is to stay out of distress at a fair cost, not to remove every swing in earnings.

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Glossary

Risk management: Choosing which risks to take, how much of each, and what to do with the rest: keep, reduce, hedge or transfer.
Risk appetite: The amount and type of risk a firm is willing to take to meet its goals.
Core risk: A risk the firm is in business to take, and is paid for: credit risk for a lender, insurance risk for an insurer.
Solvency: Having more assets than liabilities, with enough capital left over to absorb losses.
Financial distress: The state of a firm whose capital or cash is running low: still alive, but losing customers, paying more for funding and watched closely by its supervisor.
Hedge: Taking a position that gains when another loses, to make the overall result more stable.
Modigliani and Miller: Modigliani and Miller's result that, in a perfect market, how a firm is financed (and so whether it hedges) does not change its value.

Deep Dives & Origins

Deep Dives

Stulz, R. M., “Rethinking Risk Management”, Journal of Applied Corporate Finance 9(3), 1996. Intermediate.
Hull, J. C., Risk Management and Financial Institutions, 6th edition, Wiley, 2023, the introductory chapters on banks and insurers. Intermediate.

Origins

Modigliani, F. and Miller, M. H., “The Cost of Capital, Corporation Finance and the Theory of Investment”, American Economic Review 48(3), 1958.
Smith, C. W. and Stulz, R. M., “The Determinants of Firms' Hedging Policies”, Journal of Financial and Quantitative Analysis 20(4), 1985.
Froot, K. A., Scharfstein, D. S. and Stein, J. C., “Risk Management: Coordinating Corporate Investment and Financing Policies”, Journal of Finance 48(5), 1993.
Directive 2009/138/EC (Solvency II), Articles 138 and 139 on breaches of the SCR and MCR.
Board of Governors of the Federal Reserve System, Review of the Federal Reserve's Supervision and Regulation of Silicon Valley Bank, April 2023.

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