Are bank shareholders enemies of regulators or a potential source of market discipline ?

In moral hazard models, bank shareholders have incentives to transfer wealth from the deposit insurer --that is, maximize put option value-by pursuing riskier strategies. For safe banks with large charter value, however, the risk-taking incentive is outweighed by the possibility of losing charter value. Focusing on the relationship between book value, market value, and a risk measure, this paper develops a semi-parametric model for estimating the critical level of bank risk at which put option value starts to dominate charter value. From these estimates, we infer the extent to which the risk-taking incentive prevailed during 1986-92, a period characterized by serious banking problems and financial turmoil. We find that despite the difficult financial environment, shareholders’ risk-taking incentive was confined primarily to a small fraction of highly risky banks. SANGKYUN PARK is an Economist at the Office of Management and Budget. STAVROS PERISTIANI is a Research Officer in the Research and Market Analysis Group of the Federal Reserve Bank of New York. *Corresponding author, Main 3 East, Federal Reserve Bank of New York, 33 Liberty Street, New York, NY 10045. E-mail: [email protected]. We wish to thank Gijoon Hong for excellent research assistance. The views expressed in this paper are those of the authors and do not necessarily represent the views of the Federal Reserve Bank of New York, the Federal Reserve System or the Office of Management and Budget.