Bank capital regulation in a barrier option framework

Athanasios Episcopos

Journal of Banking & Finance, 2008, vol. 32, issue 8, 1677-1686

Abstract: The barrier options theory of corporate security valuation is applied to the contingent claims of a regulated bank. The regulator/insurer of a bank owns a down-and-in call option on the bank assets which can be balanced against the expected coverage cost. Raising the regulatory barrier (critical asset level triggering bank closure) leads to a transfer of wealth from stockholders to the insurer and reduces stockholder incentives to increase asset risk. Empirical tests on a sample of 152 one-bank holding companies show that regulatory barriers are priced in the stock market and are inversely related to Tier 1 leverage ratios.

Date: 2008
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