Agency Problems and Risk Taking at Banks

Abstract:     
The moral hazard problem associated with deposit insurance generates the potential for excessive risk taking on the part of bank owners. The banking literature identifies franchise value -- a firm's profit-generating potential -- as one force mitigating that risk taking. In the presence of owner/manager agency problems, managerial risk aversion may also offset the excessive risk taking that stems from moral hazard. Empirical models of bank risk have focused either on the disciplinary role of franchise value or on owner/manager agency problems. We estimate a unified model and find that both franchise value and ownership structure affect risk at banks. More important, we identify an interesting interaction effect: The relationship between ownership structure and risk is significant only at low franchise value banks -- those where moral hazard problems are most severe and where conflicts between owner and manager risk preferences are therefore strongest. Using loans to insiders as an alternative indicator of owner/manager agency problems, we find a similar interaction effect.

JEL Classification: G2, G3

working papers series