Prospect Theory in the Commercial Banking Industry

This study examines Kahneman and Tversky's prospect theory in the commercial banking industry. Prospect theory predicts increased risk-taking behavior in the presence of below-target outcomes. Fishburn redefined risk (commonly measured as dispersion about the mean outcome) as the integral of a function that is based on distance below target outcome. This study uses rates of return and the primary capital ratios of 142 U.S. commercial banks over the period 1970 through 1989 to test whether distance from target is related to dispersion about the mean and to test alternative target mechanisms. Cross-sectional medians of return on assets, return on equity, and primary capital ratio are used as target outcomes. Distance from target is defined as the difference between individual bank median and target outcome. The correlation between standard deviation of individual bank measures and distance from target is measured using Kendall's τ. Below target, the results confirm Fishburn's measure of risk and prospect theory and suggest that rates of return may be the operative target outcomes. The below-target results also suggest possible regional and size differences. Above target, distance from target is generally found to not be associated with the degree of dispersion about the mean.