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Capital levels and risk-taking propensity in financial institutions


Barone-Adesi, Giovanni; Farkas, Walter; Koch-Medina, Pablo (2014). Capital levels and risk-taking propensity in financial institutions. Accounting and Finance Research, 3(1):85-89.

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 ultimately driven by the net impact of capital levels on the default option and the franchise value. By considering the impact of the default option, our work complements and extends, within a simple Black-Scholes framework, the model used by Froot and Stein (1998) in the context of banks and by Froot (2007) in the context of insurance.

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 ultimately driven by the net impact of capital levels on the default option and the franchise value. By considering the impact of the default option, our work complements and extends, within a simple Black-Scholes framework, the model used by Froot and Stein (1998) in the context of banks and by Froot (2007) in the context of insurance.

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Additional indexing

Item Type:Journal Article, refereed, original work
Communities & Collections:03 Faculty of Economics > Department of Banking and Finance
Dewey Decimal Classification:330 Economics
Scope:Discipline-based scholarship (basic research)
Language:English
Date:1 January 2014
Deposited On:23 Jun 2014 14:12
Last Modified:06 Mar 2024 14:17
Publisher:Sciedu Press
ISSN:1927-5986
OA Status:Hybrid
Publisher DOI:https://doi.org/10.5430/afr.v3n1p85
Official URL:http://www.sciedu.ca/journal/index.php/afr/article/view/4231/2423
Other Identification Number:merlin-id:9333
  • Content: Published Version