Bank Capital and Risk Taking

Abstract

Bank risk-taking and capitalisation is studied in a continuous time model with a 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. A solution is derived for the liquidation rate in steady state and the determinants of charter value are investigated. Minimum capital standards are found to have little long-term impact on bank behaviour. Audit frequency is the principal tool for restraining moral hazard.