Bank profitability, leverage constraints, and risk-taking

Abstract

Research Question The 2008 crisis revealed a surprising amount of risk-taking in very profitable financial institutions. This seems to contradict the traditional predictions of corporate finance models where more profitable firms take less risk, because their shareholders stand to lose more if downside risks realize (Keeley, 1990). Understanding why some of the most profitable financial institutions chose to become exposed to risky market-based instruments on a large scale seems critical for both bank risk management and systemic risk regulation. Contribution In traditional corporate finance models, banks choose the risk of a portfolio of a fixed size. We show that bank risk-taking may take a different form when balance sheet size is a bank's choice. In our model, banks are endowed with a stable 'core business' and choose the size and risk of the market-based investments undertaken alongside their core business. Higher profitability of their core business enables banks to borrow more and engage in risky side activities on a larger scale. Results The model offers predictions that are consistent with some notable patterns of banks' precrisis risk-taking. One pattern is that many banks affected by the crisis were in advanced, rather than developing economies. Our model suggests that risk-taking in profitable banks is more likely when bank leverage constraints are looser, consistent with buoyant credit markets and a pre-crisis weakening of bank capital regulation in many advanced economies. Another pattern is the role of senior funding (e.g. repo) in supporting banks' pre-crisis expansion. Consistent with this evidence, our model confirms that banks' risk-taking in side investments is more severe when these can be financed with senior debt.

Instrumental-variable estimation of large-T panel-data models with common factors

“…Standard theory suggests that higher bank profitability dissuades a bank's risk taking, and thus it is associated with larger capital reserves because profitable banks stand to lose more shareholder value if downside risks realize (Keeley 1990). On the other hand, more profitable banks can borrow more and engage in risky activities on a larger scale under the presence of leverage constraints (Martynova, Ratnovski, and Vlahu 2020). A positive (negative) value of β 2 is consistent with the former (latter) interpretation.…”

The impact of corporate social responsibility on the risk of commercial banks with different levels of financial constraint

“…Another aspect worth studying is the link between financial constraints and bank risk-taking. Higher bank profitability could loosen bank financial constraints, enabling them to take on more risks (Repullo, 2004; Martynova et al , 2019). This effect is even stronger for banks with lower leverage levels (Martynova et al , 2019).…”

“…Higher bank profitability could loosen bank financial constraints, enabling them to take on more risks (Repullo, 2004; Martynova et al , 2019). This effect is even stronger for banks with lower leverage levels (Martynova et al , 2019). Together this evidence can be interpreted that lower constraints is an enabler for banks to become risk lovers.…”

Are bank capital requirements optimally set? Evidence from researchers’ views

“…21 An important subset of the literature has also explored unintended consequences of bank capital regulation as well as interactions with other forms of banking regulation, particularly liquidity requirements (Boissay and Collard, 2016;Faia, 2019;De Nicolo et al, 2014) and monetary policy (Gambacorta and Murcia, 2019;De Jonghe et al, 2019;Eickmeier et al, 2018;Meeks, 2017;Takats and Temesvary, 2019;Uluc and Wieladek, 2018). Other considerations are effects on banking competition (Corbae and D'Erasmo, 2019), liquidity in repo and other financial markets (Van Horen and Kotidis, 2018;Boissay et al, 2018;Haselmann et al, 2019;Cenedese et al, 2019), cross-border spillovers (Franch et al, 2019;Takats and Temesvary, 2019), risk-taking (Martynova et al, 2019) and portfolio rebalancing away from risky (but potentially productive) lending towards safer assets (bonds or household mortgages) (Cohen and Scatigna, 2016;Ambrocio and Jokivuolle, 2017;Juelsrud and Wold, 2018;Gropp et al, 2019;Mayordomo and Rodriguez-Moreno, 2018), the non-price terms of credit contracts (Mayordomo et al, 2019), and shift in intermediation towards shadow banks (Irani et al, 2018). Gehrig and Iannino (2018) find evidence which suggests that the introduction of internal credit risk models in regulation may have led to increased exposures to systemic risk.…”