Risk-taking in banks: does skin-in-the-game really matter?

Abstract

AbstractThe belief that bank capital helps improve stability takes for granted the idea that increases in capital are an incentive to reduce risk-taking because bank owners would have more to lose (skin-in-the-game) if their banks fail. Nevertheless, given the higher cost of capital as compared to debt, it is also possible that increases in capital would lead to higher risk-taking due to the need for banks to boost their returns. In light of these contradictory possibilities, we exploit exogenous variations of capital to empirically investigate the actual effects of capital on risk-taking. Our analyses based on a sample of nearly 1900 US Banking Holding Companies in the 1990–2020 period indicate that increasing capital actually leads to higher risk-taking, which contradicts the skin-in-the-game hypothesis. We show evidence that this relationship could be explained by the consequent increase in funding costs that creates pressure for better returns, which is normally achieved by means of taking higher risk. Our main findings are robust to a number of alternative model and sample specifications.