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
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: Suggested Citation