60 Pages Posted: 21 Aug 2003
Date Written: June 18, 2003
This paper provides a theoretical framework to investigate the relationship between banks' capitalization and risk-taking behavior. The conventional wisdom is that relatively well-capitalized banks are less inclined to increase asset risk, because the option value of deposit insurance decreases as the capital to asset ratio increases. There are, however, at least three shortcomings in the existing theories that cast doubt on the validity of the conventional wisdom: (1) Existing studies have neglected the agency problem arising from the separation of management and ownership. (2) Past studies did not consider risk-return profiles in which higher risk is associated with higher return. (3) Empirical studies on this issue provide only mixed evidence.
The aim of this paper is to shed new light on this issue by expanding existing models in two dimensions. First, by incorporating into a single model the three different incentives of three agents - the bank regulator, the shareholder, and the manager - regarding the risk determination by a bank; and second, by introducing four distinct assumptions on the characteristics of risk-return profiles. By combining these two factors, the theoretical model demonstrates that a bank's risk can either decrease or increase with capitalization depending on the relative forces of the three agents in determining asset risk and on various parametric assumptions about risk-return profiles.
Keywords: Banks' risk, Moral hazard, Bank capitalization, Option value of deposit insurance, Equity value maximization, Agency, Managerial private benefit
JEL Classification: D0, G0, G2
Suggested Citation: Suggested Citation
Jeitschko, Thomas D. and Jeung, Shin Dong, Incentives for Risk-Taking in Banking - A Unified Approach (June 18, 2003). Available at SSRN: https://ssrn.com/abstract=425443 or http://dx.doi.org/10.2139/ssrn.425443