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The Effect of Capitalization on Banks' Risk under Regulation and Managerial Moral Hazard: A Theoretical and Empirical Investigation

91 Pages Posted: 10 Dec 2004  

Thomas D. Jeitschko

Michigan State University - Department of Economics

Shin Dong Jeung

Financial Supervisory Services of Korea, DC Office

Date Written: 2004

Abstract

We investigate the relationship between banks' capitalization and risk-taking behavior. The conventional wisdom is that well-capitalized banks are less inclined to increase asset risk, because the option value of deposit insurance decreases with capitalization. There are, however, at least three shortcomings in the existing theories that cast doubt on the validity of the conventional wisdom. First, many studies neglect agency problems arising from the separation of management and ownership. Second, past studies rely on limited risk-return profiles of the asset choice set and do not consider profiles in which higher risk is associated with higher return. Finally, empirical studies on this issue provide only mixed evidence.

The aim of this article is to shed new light on this issue by expanding existing models to account for the shortcomings identified. Thus, we explicitly model three different incentives of the agents that shape risk-taking behavior in banking; regulatory bodies, shareholders, and management. We consider how the respective incentives influence the riskiness of a bank-portfolio for four distinct assumptions about the characteristics of risk-return profiles. By combining these factors, we demonstrate 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.

In the empirical study, the regression equations are modeled so that the differing incentives of the three agents are allowed to interact. The test results show differences in risk-capitalization relationships across high and low capital banks and across publicly and non-publicly traded banks. This indicates that risk-capitalization relationships are, indeed, sensitive to the relative forces of the three agents in determining asset risk.

Keywords: Banks' risk, bank capitalization, option value of deposit insurance, equity value maximization, moral hazard

JEL Classification: D0, G0, G2

Suggested Citation

Jeitschko, Thomas D. and Jeung, Shin Dong, The Effect of Capitalization on Banks' Risk under Regulation and Managerial Moral Hazard: A Theoretical and Empirical Investigation (2004). Available at SSRN: https://ssrn.com/abstract=629414 or http://dx.doi.org/10.2139/ssrn.629414

Thomas D. Jeitschko (Contact Author)

Michigan State University - Department of Economics ( email )

110 Marshall-Adams Hall
East Lansing, MI 48824
United States
517-355-8302 (Phone)
517-432-1068 (Fax)

HOME PAGE: http://www.msu.edu/~jeitschk/

Shin Dong Jeung

Financial Supervisory Services of Korea, DC Office ( email )

1701 K St., NW unit 1050
District of Columbia, DC 20006
United States
703 927 1308 (Phone)

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