The Effects of Closure Policies on Bank Risk-Taking

Abstract

This paper models bank closure policy for a risk-averse bank that enjoys flat-rate deposit insurance. We find that increasing the level of net worth at which banks are closed can increase or decrease induced risk aversion, as well as increase the likelihood that marginally healthy banks would be subject to extreme moral hazard. These result suggest that more timely closure policies should be imposed in conjunction with greater monitoring of bank portfolio risk and with restrictions on risk-taking for marginally healthy banks. In addition, we find that changes in closure policy can increase or decrease desired leverage and that this effect depends on the degree of correlation among asset returns.

Keywords: bank regulation, moral hazard

JEL Classification: G21, G28