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Ambiguity preferences, risk taking and the banking firm

Udo Broll (), Peter Welzel () and Kit Pong Wong
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Udo Broll: Technische Universität Dresden
Kit Pong Wong: University of Hong Kong

Eurasian Economic Review, 2018, vol. 8, issue 3, 343-353

Abstract: Abstract This paper examines the risk taking behavior of a banking firm facing ambiguity and possessing smooth ambiguity preferences. Ambiguity is modeled by a second-order probability distribution that captures the bank’s uncertainty about which of the subjective beliefs govern the return on its loans. Ambiguity aversion is modeled by a concave transformation of the (first-order) expected utility of profit conditional on each plausible subjective distribution of the random loan return. Within this framework, we show that the bank finds it less attractive to take risk in the presence than in the absence of ambiguity. This result extends to the case of greater ambiguity aversion. Given that the bank’s smooth ambiguity preferences exhibit non-increasing absolute ambiguity aversion, imposing a more stringent capital requirement to the bank has the desired effect that limits the bank’s incentive to take on excessive risk.

Keywords: Ambiguity; Ambiguity aversion; Banking firms; Capital requirements (search for similar items in EconPapers)
JEL-codes: D01 D81 G11 G12 (search for similar items in EconPapers)
Date: 2018
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