Bank Decision on Capital and Risk Under Capital Regulation

This paper models bank behavior with respect to capital and risk decisions under capital regulation using an option theoretic approach. We assume that regulatory costs are imposed on equity holders if the bank fails to meet minimum capital requirements at the end of period. Incorporating regulatory cost constraints into a contingent claim model of bank equity, equity holder payoffs are derived from an option pricing framework. Linear regulatory costs allow analytic closed from solutions. Numerical simulations suggest that bank decisions on capital and risk depend on initial capital-asset ratios, asset risk, charter value, minimum capital requirements, and regulatory costs. Contrary to previous literature, capital regulation gives two different incentives to banks depending on the extent of capitalization. Most banks have incentives to increase capital-asset ratios and reduce risk-taking strategies. Importantly, however, poorly undercapitalized banks tend to adopt go-for-broke strategies.

Name thesis:degree_name

Ph.D.

Level thesis:degree_level

Dissertation

Discipline thesis:degree_discipline

Finance

Grantor

University of Illinois at Urbana-Champaign

Year dc:date

2014

Author dc:creator

• Kim, Duck-Young

Contributors dc:contributor

• Lynge, Morgan J., Jr.

• Economics, Finance
• Business Administration, Banking

Identifier

(UMI)AAI9329083

OAI identifier oai:identifier

oai:www.ideals.illinois.edu:2142/72586