Bank Profitability and Risk-Taking

Natalya Martynova, Lev Ratnovski () and Razvan Vlahu

No 2015/249, IMF Working Papers from International Monetary Fund

Abstract: Traditional theory suggests that more profitable banks should have lower risk-taking incentives. Then why did many profitable banks choose to invest in untested financial instruments before the crisis, realizing significant losses? We attempt to reconcile theory and evidence. In our setup, banks are endowed with a fixed core business. They take risk by levering up to engage in risky ‘side activities’(such as market-based investments) alongside the core business. A more profitable core business allows a bank to borrow more and take side risks on a larger scale, offsetting lower incentives to take risk of given size. Consequently, more profitable banks may have higher risk-taking incentives. The framework is consistent with cross-sectional patterns of bank risk-taking in the run up to the recent financial crisis.

Keywords: WP; interest rate; monetary policy; Banks; Risk-Taking; Bank Capital; Repo Markets; Crises; market-based investment; risky investment; investment X; side investment; project investment; Bank soundness; Accommodative monetary policy; Investment banking; Stocks; Global (search for similar items in EconPapers)
Pages: 43
Date: 2015-11-25
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Citations: View citations in EconPapers (16)

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