Working paper No. 90
Alistair Milne and A Elizabeth Whalley
We study bank risk-taking and capitalisation in a continuous time model with closed-form solution, assuming uncertain cash flow, random regulatory audit and a constraint on equity issue. Capital reserves are built up towards a desired level as an insurance against the threat of liquidation. Risk-taking is a discontinuous function of the level of capital. We solve in steady-state for the liquidation rate and investigate the determinants of charter value. Minimum capital standards have little long-term impact on behaviour. Audit frequency is the principal tool for restraining moral hazard.
Bank Capital and Risk-Taking