Capital Levels and Risk-Taking Propensity in Financial Institutions

Giovanni Barone-Adesi, Walter Farkas and Pablo Koch-Medina

Accounting and Finance Research, 2014, vol. 3, issue 1, 85

Abstract: Regulators dedicate much attention to a financial institution’s option to default, i.e. the option that distressed ï¬ nancial 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 ï¬ rm capital close to the minimal requirement. We argue, however, that undercapitalization harms proï¬ table 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.

Date: 2014
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Persistent link: https://EconPapers.repec.org/RePEc:jfr:afr111:v:3:y:2014:i:1:p:85

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