Hedging incentives for financial institutions

Using a simple model, I derive two results that provide guiding principles for hedging by, and capital regulation of, financial institutions. First, the adoption of value-maximizing hedging strategies by financial institutions minimizes the volatility of the regulatory capital ratio. The hedging incentives for financial institutions can therefore differ from those of nonfinancial firms, as it is commonly argued that nonfinancial firms have an incentive to reduce the volatility of cashflows. Second, asset substitution incentives for financial institutions are eliminated if and only if the regulatory capital ratio correlates perfectly with the market value of equity. This implies that, in order to eliminate asset substitution incentives for financial institutions, it is not sufficient for the capital requirements to be proportional to the systematic risks (the betas) of the assets. This result is consistent with the regulatory response to the global financial crisis, as the Basel III regulatory framework for banks focuses on aligning the regulatory definition of available capital with the market value of equity.