43 Pages Posted: 23 Feb 2017 Last revised: 25 Feb 2017
Date Written: February 21, 2017
We present a model where bank assets are a portfolio of risky debt claims and analyze equityholders' risk-taking behavior while considering the strategic interaction between debtors and creditors. We fnd that: (1) as the leverage of a bank increases, risk shifting by borrowers increases, even if their leverage is unchanged (zombie lending). (2) While the literature demonstrates that an increase in co-movement of a loan portfolio increases the bank's cost of default directly, we show that the increase prevails through a second channel: an increase in risk shifting. (3) Risk shifting decreases with the diversification of a loan portfolio.
Keywords: Risk taking, Banks, Co-movements, Deposit insurance, Zombie lending
JEL Classification: G21, G28, G32, G38
Suggested Citation: Suggested Citation
Peleg, Sharon and Raviv, Alon, The Risk Spiral - The Effects of Bank Capital and Diversification on Risk Taking (February 21, 2017). Available at SSRN: https://ssrn.com/abstract=2921542 or http://dx.doi.org/10.2139/ssrn.2921542