Risk-taking behavior of banks under regulation

This paper analyzes the value maximization of regulated banks within a moral-hazard framework. In the model, regulators monitor both the capital ratio and the asset portfolio, and banks simultaneously select the optimum capital ratio and asset portfolio. A key assumption is that a bank cannot expect a positive put option value once it is classified as risky by regulators. The optimum values of the two variables depend on investment opportunities and charter values, as well as regulatory parameters. The model that explicitly incorporates regulation can explain various phenomena that are seemingly inconsistent with the predictions of moral hazard models — for example, a positive relationship between the capital ratio and the riskiness of the asset portfolio. A particularly interesting result is that a larger charter value results in a higher-risk interior solution.