Bank Risk Dynamics Where Assets Are Risky Debt Claims
40 Pages Posted: 3 Jun 2016 Last revised: 23 Jun 2016
Date Written: June 1, 2016
The structural approach views firm's equity as a call option on the value of its assets, which motivates stockholders to increase risk. However, since bank assets are risky debt claims, bank equity resembles a subordinated debt. Using this assumption, and considering the strategic interaction between a bank and its debtor, we argue that risk shifting is limited to states in which the debtor is in financial distress. Furthermore, risk shifting increases with bankruptcy costs and decreases with bank capital. Thus, increasing a bank's capital affects stability, not only through the additional capital buffer, but also by affecting the risk shifting incentive.
Keywords: Risk taking, Asset risk, Financial institutions, Stress test, Leverage
JEL Classification: G21, G28, G32, G38
Suggested Citation: Suggested Citation