Bank capital and risk taking

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 15 January 1999

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.

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