Opaque Bank Assets and Optimal Equity Capital
87 Pages Posted: 2 Jun 2016 Last revised: 8 Jan 2018
Date Written: January 3, 2018
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
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