Capital Levels and Risk-Taking Propensity in Financial Institutions

Regulators dedicate much attention to a financial institution’s option to default, i.e. the option that distressed financial 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 firm capital close to the minimal requirement. We argue, however, that undercapitalization harms profitable 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. DOI: https://doi.org/10.5430/afr.v3n1p85 Posted at the Zurich Open Repository and Archive, University of Zurich ZORA URL: https://doi.org/10.5167/uzh-96663 Published Version Originally published at: Barone-Adesi, Giovanni; Farkas, Walter; Koch-Medina, Pablo (2014). Capital levels and risk-taking propensity in financial institutions. Accounting and Finance Research, 3(1):85-89. DOI: https://doi.org/10.5430/afr.v3n1p85 www.sciedu.ca/afr Accounting and Finance Research Vol. 3, No. 1; 2014 Published by Sciedu Press 85 ISSN 1927-5986 E-ISSN 1927-5994 Capital Levels and Risk-Taking Propensity in Financial Institutions Giovanni Barone-Adesi, Walter Farkas & Pablo Koch-Medina 1 Swiss Finance Institute, University of Lugano, Switzerland 2 Department of Banking and Finance, University of Zurich and Department of Mathematics, ETH Zürich, Switzerland 3 Center for Finance and Insurance, University of Zurich, Switzerland Received: January 17, 2014 Accepted: February 3, 2014 Online Published: February 16, 2014 doi:10.5430/afr.v3n1p85 URL: http://dx.doi.org/10.5430/afr.v3n1p85 Partial support through the SNF project 51NF40-144611 “Capital adequacy, valuation, and portfolio selection for insurance companies” is gratefully acknowledged. Part of this research was supported by Swiss Re.