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Bank capital and risk taking

  • Alistair Milne
  • A Elizabeth Whalley

Bank risk-taking and capitalisation is studied in a continuous time model with a closed form solution, assuming uncertain cash flow, random regulatory audit, and a constraint on equity issue. Capital reserves are built up towards a desired level as an insurance against the threat of liquidation. Risk-taking is a discontinuous function of the level of capital. A solution is derived for the liquidation rate in steady state and the determinants of charter value are investigated. Minimum capital standards are found to have little long-term impact on bank behaviour. Audit frequency is the principal tool for restraining moral hazard.

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Paper provided by Bank of England in its series Bank of England working papers with number 90.

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Date of creation: Jan 1999
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Handle: RePEc:boe:boeewp:90
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