Scandinavian Working Papers in Economics

Research Papers in Economics,
Stockholm University, Department of Economics

No 2015:3: Dynamic Banking with Endogenous Risk Based Funding Cost: Value Maximization, Risk-taking, Responses to Regulation and Credit Contraction

Bo Larsson () and Hans Wijkander ()
Additional contact information
Bo Larsson: Dept. of Economics, Stockholm University, Postal: Department of Economics, Stockholm University, S-106 91 Stockholm, Sweden
Hans Wijkander: Dept. of Economics, Stockholm University, Postal: Department of Economics, Stockholm University, S-106 91 Stockholm, Sweden

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

JEL-codes: C61; G21; G22

46 pages, March 9, 2015

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