Agency problems and risk taking at banks

The moral hazard problem associated with deposit insurance generates the potential for excessive risk taking on the part of bank owners. The banking literature identifies franchise value--a firm's profit-generating potential--as one force mitigating that risk taking. We argue that in the presence of owner/manager agency problems, managerial risk aversion may also offset the excessive risk taking that stems from moral hazard. Empirical models of bank risk tend to focus either on the disciplinary role of franchise value or on owner/manager agency problems. We estimate a unified model and find that both franchise value and ownership structure affect risk at banks. More important, we identify an interesting interaction effect: The relationship between ownership structure and risk is significant only at low-franchise value banks--those where moral hazard problems are most severe and where conflicts between owner and manager risk preferences are therefore strongest. For these banks, insider holdings affect risk taking through asset risk, while ownership concentration affects risk taking through leverage. This is consistent with the idea that outside blockholders more readily control managerial risk-taking by influencing leverage than by influencing asset risk.