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Capital Levels and Risk-Taking Propensity in Financial Institutions

Author

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  • Giovanni Barone-Adesi
  • Walter Farkas
  • Pablo Koch-Medina

Abstract

Regulators dedicate much attention to a financial institution’s option to default, i.e. the option that distressed ï¬ nancial institutions have to transfer losses to their creditors. It is generally recognized that the existence of this option provides intermediaries with a powerful incentive to keep ï¬ rm capital close to the minimal requirement. We argue, however, that undercapitalization harms proï¬ table growth opportunities, i.e. the institution’s franchise value. Indeed, the capitalization of a financial institution will be ultimately driven by the net impact of capital levels on the default option and the franchise value. By considering the impact of the default option, our work complements and extends, within a simple Black-Scholes framework, the model used by Froot and Stein (1998) in the context of banks and by Froot (2007) in the context of insurance.

Suggested Citation

  • Giovanni Barone-Adesi & Walter Farkas & Pablo Koch-Medina, 2014. "Capital Levels and Risk-Taking Propensity in Financial Institutions," Accounting and Finance Research, Sciedu Press, vol. 3(1), pages 1-85, February.
    • Handle: RePEc:jfr:afr111:v:3:y:2014:i:1:p:85
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    References listed on IDEAS

    as
    1. Jokipii, Terhi & Milne, Alistair, 2011. "Bank capital buffer and risk adjustment decisions," Journal of Financial Stability, Elsevier, vol. 7(3), pages 165-178, August.
    2. Berger, Allen N, 1995. "The Relationship between Capital and Earnings in Banking," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(2), pages 432-456, May.
    3. David F. Babbel & Craig Merrill, 2005. "Real and Illusory Value Creation by Insurance Companies," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 72(1), pages 1-22, March.
    4. Demirguc, Asli & Huizinga, Harry, 1999. "Determinants of Commercial Bank Interest Margins and Profitability: Some International Evidence," The World Bank Economic Review, World Bank, vol. 13(2), pages 379-408, May.
    5. Kenneth A. Froot, 2007. "Risk Management, Capital Budgeting, and Capital Structure Policy for Insurers and Reinsurers," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 74(2), pages 273-299, June.
    6. Froot, Kenneth A. & Stein, Jeremy C., 1998. "Risk management, capital budgeting, and capital structure policy for financial institutions: an integrated approach," Journal of Financial Economics, Elsevier, vol. 47(1), pages 55-82, January.
    7. Furlong, Frederick T. & Keeley, Michael C., 1989. "Capital regulation and bank risk-taking: A note," Journal of Banking & Finance, Elsevier, vol. 13(6), pages 883-891, December.
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    JEL classification:

    • R00 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - General - - - General
    • Z0 - Other Special Topics - - General

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