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Dynamic Banking with Endogenous Risk Based Funding Cost: Value Maximization, Risk-taking, Responses to Regulation and Credit Contraction

Author

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  • Larsson, Bo

    (Dept. of Economics, Stockholm University)

  • Wijkander, Hans

    (Dept. of Economics, Stockholm University)

Abstract

We develop a stochastic dynamic model of bank value maximization under limited liability and in which bankruptcy can occur. Main issues are banks’ optimal responses to regulation and credit-losses. We show that risk-neutral banks behave as if they were risk-averse when they are under-capitalized. Risk-taking is always below that of single period value maximization under limited liability. We also show that banking regulations often have significant and adverse second-order effects through banks’ dynamic adjustment to regulations. The model gives rise to endogenous capital buffers and shows that it takes time to re-build bank capital after a credit-loss. That makes the model suitable to analysis of situations as the current post financial crisis period with large macroeconomic disturbances and credit contraction.

Suggested Citation

  • Larsson, Bo & Wijkander, Hans, 2015. "Dynamic Banking with Endogenous Risk Based Funding Cost: Value Maximization, Risk-taking, Responses to Regulation and Credit Contraction," Research Papers in Economics 2015:3, Stockholm University, Department of Economics.
  • Handle: RePEc:hhs:sunrpe:2015_0003
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    References listed on IDEAS

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    More about this item

    Keywords

    Dynamic Banking; Banking regulation; Capital adequacy; Dividends; Incentive structure; Capital buffers; Bankruptcy;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies

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