Strategic Risk Management with Externalities

This paper studies the dynamic risk management of highly-levered financial institutions within a structural model of credit risk. We consider a context in which systemic default induces externalities that amplify the private cost of financial distress. This represents a source of strategic interaction and mandates an analysis of financial institutions' asset allocations in coalescence. We derive a unique strategic equilibrium in which two similar financial institutions adopt polarized and stochastic risk management, without sacrificing full diversification. Both institutions are concerned with maintaining sufficient wealth in adverse states. However, the conservative institution reduces its risk exposure, whereas the aggressive institution optimally gambles on positive and negative outcomes by taking long and short positions in risky securities over time. We further analyze the implications for debt pricing and distress probabilities