Bank Capital and Risk-Taking: Evidence from Misconduct Provisions

Abstract

Over the last decade, banks around the world have been confronted with substantial misconduct costs. We employ provisions for misconduct costs as an instrumental variable to identify the causal effect of a bank capital shock on risk-taking. Using new hand-collected data, we show that misconduct provisions have adversely affected bank capital across U.K. banks. Our instrumental variable approach additionally exploits an important difference in timing between current risk-taking and the past misconduct that current misconduct provisions refer to. Our main finding is that a negative bank capital shock causes an increase in risk-taking in the U.K. mortgage market.