Capital levels and risk-taking propensity in financial institutions

Abstract

Regulators dedicate much attention to a financial institution’s option to default, i.e. the option that distressed financial institutions have to transfer losses to their creditors. It is generally recognized that the existence of this option provides intermediaries with a powerful incentive to keep firm capital close to the minimal requirement. We argue, however, that undercapitalization harms profitable growth opportunities, i.e. the institution’s franchise value. Indeed, the capitalization of a financial institution will be ultimat Show more