Opaque Bank Assets and Optimal Equity Capital

87 Pages Posted: 2 Jun 2016 Last revised: 8 Jan 2018

Min Dai

National University of Singapore (NUS) - Department of Mathematics

Shan Huang

National University of Singapore (NUS)

Jussi Keppo

National University of Singapore - NUS Business School

Date Written: January 3, 2018

Abstract

Banks' assets are opaque, and therefore, we model their true accounting asset values as partially observed variables. We derive a stochastic control model to optimize banks' dividend and recapitalization policies in this situation, and calibrate that to a sample of U.S. banks. By the calibrated model, the noise in reported accounting asset values hides about one-third of the true asset return volatility and raises the banks' market equity value by 7.8% because the noise hides the banks' solvency risk from banking regulators. Particularly, those banks with a high level of loan loss provisions, nonperforming assets, and real estate loans, and with a low volatility of reported total assets have noisy accounting asset values. Because of the substantial shock on the true asset values, the banks' assets were more opaque during the recent financial crisis.

Keywords: bank capital, dividends, investment, earnings smoothing, banking regulation

JEL Classification: G21, G28, G32, G35

Suggested Citation

Dai, Min and Huang, Shan and Keppo, Jussi, Opaque Bank Assets and Optimal Equity Capital (January 3, 2018). Available at SSRN: https://ssrn.com/abstract=2787815 or http://dx.doi.org/10.2139/ssrn.2787815

Min Dai

National University of Singapore (NUS) - Department of Mathematics ( email )

Singapore

Shan Huang

National University of Singapore (NUS) ( email )

Bukit Timah Road 469 G
Singapore, 117591
Singapore

Jussi Keppo (Contact Author)

National University of Singapore - NUS Business School ( email )

1 Business Link
Singapore, 117592
Singapore

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