Bank Risk Dynamics where Assets are Risky Debt Claims
According to the basic structural approach bank aggregated asset value follows a log-normal process. As a result shareholders are motivated to transfer wealth from bondholders by engaging in risky projects. However, bank assets usually consist of a portfolio of risky loans to several corporate borrowers. Using these assumptions, we show that risk shifting is limited to states in which the debtor is in financial distress. A diversified loans portfolio decreases risk shifting. Moreover, the optimal level of asset risk decreases as the portfolio is less correlated. Furthermore, we show that for a given leverage ratio, the level of risk of a borrower may increase if the quality of the bank’s entire portfolio deteriorates.
Area: Financial Regulation and Supervision
Keywords: Risk taking, Asset risk, Financial institutions, diversification , Leverage
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