Research Papers in Economics, Department of Economics, Stockholm University
Dynamic Banking with Endogenous Risk Based Funding Cost: Value Maximization, Risk-taking, Responses to Regulation and Credit Contraction
() and Hans Wijkander
Abstract: We develop a stochastic dynamic model of bank value
maximization under limited liability and in which bankruptcy can occur.
Main issues are banks’ optimal responses to regulation and credit-losses.
We show that risk-neutral banks behave as if they were risk-averse when
they are under-capitalized. Risk-taking is always below that of single
period value maximization under limited liability. We also show that
banking regulations often have significant and adverse second-order effects
through banks’ dynamic adjustment to regulations. The model gives rise to
endogenous capital buffers and shows that it takes time to re-build bank
capital after a credit-loss. That makes the model suitable to analysis of
situations as the current post financial crisis period with large
macroeconomic disturbances and credit contraction.
Keywords: Dynamic Banking; Banking regulation; Capital adequacy; Dividends; Incentive structure; Capital buffers; Bankruptcy; (follow links to similar papers)
JEL-Codes: C61; G21; G22; (follow links to similar papers)
46 pages, March 9, 2015
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