Are Bank Shareholders Enemies of Regulators or a Potential Source of Market Discipline?

40 Pages Posted: 2 Aug 2006 Last revised: 15 Feb 2009

See all articles by Sangkyun Park

Sangkyun Park

Independent

Stavros Peristiani

Federal Reserve Bank of New York--Retired

Date Written: October 2006

Abstract

In moral hazard models, bank shareholders have incentives to transfer wealth from the deposit insurer - that is, maximize put option value - by pursuing riskier strategies. For safe banks with large charter value, however, the risk-taking incentive is outweighed by the possibility of losing charter value. Focusing on the relationship between book value, market value, and a risk measure, this paper develops a semi-parametric model for estimating the critical level of bank risk at which put option value starts to dominate charter value. From these estimates, we infer the extent to which the risk-taking incentive prevailed during 1986-92, a period characterized by serious banking problems and financial turmoil. We find that despite the difficult financial environment, shareholders' risk-taking incentive was confined primarily to a small fraction of highly risky banks.

Keywords: market discipline, charter value, put option value, spline estimation

JEL Classification: G21, G28

Suggested Citation

Park, Sangkyun and Peristiani, Stavros, Are Bank Shareholders Enemies of Regulators or a Potential Source of Market Discipline? (October 2006). FRB of New York Staff Report No. 138, Available at SSRN: https://ssrn.com/abstract=921613 or http://dx.doi.org/10.2139/ssrn.921613

Stavros Peristiani

Federal Reserve Bank of New York--Retired ( email )

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