Fatefully Interconnected: Hidden Links between Bank Capital and Asset Risk

30 Pages Posted: 5 Jun 2013 Last revised: 13 Nov 2013

Date Written: September 6, 2013

Abstract

This paper derives inner solutions for banks' leverage and asset risk choices in a trade-off framework, thereby revealing important and previously unknown interactions between both decision variables. The model demonstrates that risk and capital choices are not only directly affected by changes in exogenous parameters, but are also indirectly influenced by the subsequent shift of the other decision variable. These indirect effects can potentially even outweigh the direct effects, which then leads to counterintuitive results. This analysis offers an explanation for mixed empirical findings and yields important policy implications.

Keywords: bank risk, capital structure, leverage, monetary policy, franchise value

JEL Classification: G21, G28, G32

Suggested Citation

Eufinger, Christian, Fatefully Interconnected: Hidden Links between Bank Capital and Asset Risk (September 6, 2013). Available at SSRN: https://ssrn.com/abstract=2274145 or http://dx.doi.org/10.2139/ssrn.2274145

Christian Eufinger (Contact Author)

IESE Business School ( email )

Avinguda de Pearson, 21
Barcelona, 08034
Spain

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