Excessive Risk-taking Research Articles

Monetary Policy and Financial Stability: Lessons from the Global Financial Crisis

The Global Financial Crisis (GFC) of 2007-2008 was a watershed moment that reshaped the landscape of monetary policy and financial regulation worldwide. This research paper delves into the pivotal role of monetary policy in fostering financial stability, drawing lessons from the tumultuous events of the GFC. Through an extensive review of literature and empirical analysis, this paper examines the various monetary policy tools employed by central banks to mitigate systemic risks and promote stability in the aftermath of the crisis. The paper begins by elucidating the complex interplay between monetary policy, financial markets, and systemic risk, emphasizing the importance of maintaining a delicate balance between price stability and financial stability. It explores the conventional and unconventional measures adopted by central banks during the crisis, including interest rate adjustments, liquidity provision, and asset purchase programs, and assesses their effectiveness in stabilizing financial markets and averting systemic collapse. Furthermore, the paper evaluates the evolution of monetary policy frameworks in response to the lessons learned from the GFC, such as the adoption of macroprudential tools and the reassessment of inflation targeting regimes. It analyzes the challenges and trade-offs faced by policymakers in pursuing dual objectives of price and financial stability, highlighting the need for a holistic approach to monetary policy formulation. Moreover, this paper examines the implications of post-crisis monetary policy measures on financial markets, asset prices, and economic activity, addressing concerns regarding moral hazard, excessive risk-taking, and asset price bubbles. It also discusses the role of regulatory reforms in strengthening the resilience of the financial system and enhancing the effectiveness of monetary policy transmission mechanisms.

Information advantages, excessive risk-taking, and capital regulation for BigTechs in financial intermediation

This paper establishes theoretical models to study capital regulation of BigTech firms (BigTechs hereafter) providing financial intermediation services. In our models, BigTechs borrow debts to invest between socially efficient prudent assets and socially inefficient risky assets. Limited liabilities imply that with a higher capital adequacy ratio, BigTechs are more risk averse and favor the prudent asset more. Then we examine how better information of BigTechs will affect BigTechs' incentive for excessive risk-taking, welfare, and capital regulation. The major results produced by our models are as follows: (1) Better information of BigTechs does not eliminate and could in some circumstances exacerbate their excessive risk-taking behavior. (2) Better information of BigTechs does not necessarily improve welfare. BigTechs could employ better information to more precisely identify the socially inefficient risky asset to invest in, causing more severe resource misallocation. (3) Capital regulation is an effective tool to curb BigTechs' excessive risk-taking and to ensure that better information of BigTechs will improve welfare.

Audit committee attributes and Islamic bank risk-taking behavior

PurposeThis study aims to investigate the relationship between audit committee (AC) attributes and the risk-taking behavior of Islamic banks.Design/methodology/approachThe study used data generated from the annual reports of 43 full-fledged Islamic banks operating in 15 countries between 2010 and 2020.FindingsThe findings indicate that AC size, AC independence and the proportion of AC members from foreign countries have a significant negative relationship with the risk-taking of Islamic banks. However, AC meetings, AC gender diversity and the proportion of AC members with doctorate degrees have insignificantly influenced the risk-taking of Islamic banks.Research limitations/implicationsThe study used only six AC attributes out of corporate governance mechanisms likely to affect the insolvency risk of full-fledged Islamic banks between 2010 and 2020.Practical implicationsThe study sheds light on the effects of AC attributes on the risk-taking of Islamic banks. The findings could allow policymakers and regulators to provide policies and regulations that could improve AC’s oversight role in constraining Islamic banks from excessive risk-taking. Besides, this study can guide the board of directors in appointing AC members who can prevent Islamic banks from taking excessive risks.Originality/valueThis study provides clear and adequate empirical evidence showing how key audit committee attributes influence the risk-taking behavior of full-fledged Islamic banks.

The importance of dynamic risk constraints for limited liability operators

Previous literature shows that prevalent risk measures such as value at risk or expected shortfall are ineffective to curb excessive risk-taking by a tail-risk-seeking trader with S-shaped utility function in the context of portfolio optimisation. However, these conclusions hold only when the constraints are static in the sense that the risk measure is just applied to the terminal portfolio value. In this paper, we consider a portfolio optimisation problem featuring S-shaped utility and a dynamic risk constraint which is imposed throughout the entire trading horizon. Provided that the risk control policy is sufficiently strict relative to the Sharpe ratio of the asset, the trader’s portfolio strategies and the resulting maximal expected utility can be effectively constrained by a dynamic risk measure. Finally, we argue that dynamic risk constraints might still be ineffective if the trader has access to a derivatives market.

Regulation of Markets that Pose a Less Systemic Risk—The Crypto Asset Market Is an Example

It has been argued that ‘Some markets pose a such little systemic risk to the overall financial system that they should never be regulated.’ However, even markets that are small and pose less systemic risk should also be regulated scientifically and appropriately. The crypto-asset market is currently one of the markets that the Financial Conduct Authority regulates to a lesser extent, so this paper uses this as an example to analyse the various risks that the crypto-asset market may pose in terms of consumer protection, financial crime, and systemic risk, and then explores a series of regulatory measures that the Financial Conduct Authority is currently taking to address these risks, such as consumer protection guidance, anti-money laundering directives, regulatory The discussion then explores the range of regulatory measures currently being taken by the FCA to address these risks, such as consumer protection guidance, anti-money laundering directives, regulatory sandboxes, etc. Finally, the need for effective regulation of financial markets is analysed in terms of enhancing consumer confidence, promoting financial innovation, and protecting good financial competition. In this way, it is concluded that the financial regulatory system should have to adhere to prudential regulation and strict supervision to maintain market order and prevent excessive risk-taking.

Competition, risk-taking behavior and stability of commercial banks: evidence from Kenya

PurposeThis study analyzes the effects of competition and risk-taking behavior on the stability of commercial banks in Kenya.Design/methodology/approachAn unbalanced panel dataset of 36 licensed commercial banks in Kenya for 2001–2020 was extracted from the published financial statements. A dynamic panel data analysis model, a two-step system generalized method of moments (GMM), was employed.FindingsThe results indicate that competition reinforces bank stability, whereas banks’ risk-taking behavior has an inverse relationship with strength.Practical implicationsThe study confirms the competition-stability nexus, implying that measures may be implemented to foster competition among banks with reduced concentration. These measures may include, but are not limited to, reduced entry barriers and optimal capital requirements. Second, efforts should be made to ensure excessive risk-taking by banks. Employing an elaborate exposure monitoring system with clear warning signs is recommended.Originality/valueThis study is unique in several ways. First, it employs structural and nonstructural measures of competition and ex post standards of banks’ risk-taking behavior. Second, contrary to past studies, this study uses various firm-level measures of bank stability. Lastly, it provides essential empirical evidence from the context of a developing economy, whose institutional and macroeconomic environments differ significantly from those of a developed economy.

Fund ownership, wealth, and risk-taking: Evidence on private equity managers

Private equity (PE) managers are required to invest their own money in the funds they manage. We examine the incentive effects of this ownership on the delegated acquisition decision. A simple model shows that PE managers select less risky firms and use more debt, the higher their ownership. We test these predictions for a sample of Norwegian PE funds, using managers’ wealth to capture their relative risk aversion. As predicted, the target company’s cash-flow risk decreases and leverage increases with the manager’s ownership scaled by wealth. Moreover, the overall portfolio risk decreases with ownership, mitigating widespread concerns about excessive risk-taking.

The Role of Financial Risks and Financial Sustainability in the Iraqi Stock Markets during COVID-19 Pandemic

This paper compares the company's ability to sustain a diversified resource base for long-term service to its customers without need for external funding sources through two stressful systems of financial markets, the financial crisis aftermath 2008 and the COVID-19 epidemic. Our findings indicate that financial sustainability has been affected by disasters. Banks can impose significant risks on the economy, one of the main concerns about the causes of the current financial crisis is that banks engaged in excessive risk-taking, it has faced during the 2008 crisis liquidity and credit risks, while Through the 2020 crisis which is the COVID-19 pandemic crisis, the most significant financial risks that banks experienced were credit risks due to banks ’dependence on traditional, weak, safe assets, including the dollar, the Swiss franc, and other treasury bonds during the COVID-19 pandemic. This led to a lack of cash reserves held by banks, which led to weak investor tolerance towards financial risks, especially as the nature of crises is changing, as the results have proven that departures from riskiest directorships are more beneficial during the COVID-19 crisis because managers deal with the crisis in the same way as a crisis 2008 On the other hand, departures from riskiest directorships lead to higher administrative costs due to a lack of expertise.

Why Do We Need to Examine Leadership Concepts and Styles in Finance? Literature Overview

In the contemporary world, leadership concepts are associated with managerial literature. As a rule, scholars define a leader as a person with a certain set of positive characteristics that enable them to lead people and contribute to the successful development of a company. However, the concept of financial efficiency has to be factored into the effective developmentof a company. At the same time, personal characteristics of top managers, such as overconfidence, narcissism, excessive risk-taking, usually have a negative connotation in financial literature.
 This review includes a study of the development of various leadership concepts in management-related literature. The leader’s main personal characteristics are highlighted according to the literature. It also explores the relationship between the concepts of a leader and a manager. The literature devoted to the relationship between the concept of a transformationalleader and company performance has also been studied. The key conclusion of this literature review is that certain personal characteristics of top managers can have a positiveeffect on a company’s performance if they are considered from the point of view of transformational leadership. This confirms the need for a deeper study of the relationship between managers’ personal characteristics and a company’s financial efficiency, especially in the context of sustainable development and the concept of transformational leadership.

Capitalism and Distributive Justice: Musings of a Mormon Economist

Capitalism and Distributive Justice: Musings of a Mormon Economist

A reinforcement learning approach to improve the performance of the Avellaneda-Stoikov market-making algorithm.

Market making is a high-frequency trading problem for which solutions based on reinforcement learning (RL) are being explored increasingly. This paper presents an approach to market making using deep reinforcement learning, with the novelty that, rather than to set the bid and ask prices directly, the neural network output is used to tweak the risk aversion parameter and the output of the Avellaneda-Stoikov procedure to obtain bid and ask prices that minimise inventory risk. Two further contributions are, first, that the initial parameters for the Avellaneda-Stoikov equations are optimised with a genetic algorithm, which parameters are also used to create a baseline Avellaneda-Stoikov agent (Gen-AS); and second, that state-defining features forming the RL agent's neural network input are selected based on their relative importance by means of a random forest. Two variants of the deep RL model (Alpha-AS-1 and Alpha-AS-2) were backtested on real data (L2 tick data from 30 days of bitcoin-dollar pair trading) alongside the Gen-AS model and two other baselines. The performance of the five models was recorded through four indicators (the Sharpe, Sortino and P&L-to-MAP ratios, and the maximum drawdown). Gen-AS outperformed the two other baseline models on all indicators, and in turn the two Alpha-AS models substantially outperformed Gen-AS on Sharpe, Sortino and P&L-to-MAP. Localised excessive risk-taking by the Alpha-AS models, as reflected in a few heavy dropdowns, is a source of concern for which possible solutions are discussed.

Should managers be incentivized with stock or options? Evidence from China

Which type of managerial compensation—stock or options—is more effective as an incentive to maximize shareholder value and curb excessive risk-taking has been debated often in the literature. By investigating the stock and option grants by Chinese firms from 2005 to 2015, we find that higher past stock return volatility increases the preference for stock over options, while a significant upward trend in stock price results in a tendency to choose options over stock. Both stock and option grants as forms of managerial compensation lead to better financial performance, with no significant difference. We present evidence to exclude earnings management as the source of improvement in financial performance. Firms using stock as compensation exhibit higher productivity than those using options. In contrast, there is no improvement in managerial ability from using either stock or options as compensation. Our study deepens the understanding of the relationship between the composition of managerial compensation and firm performance.

The interrelationships between bank risk and market discipline in Southeast Asia

PurposeThe purpose of this study is to examine whether a bidirectional relationship between bank risk and market discipline may exist in Southeast Asia.Design/methodology/approachA simultaneous equations model with a three-stage least squares estimator is used to examine the interrelationships between bank risk and market discipline using a sample of 79 listed banks in five countries in Southeast Asia (ASEAN-5) from 2006 to 2019.FindingsThe findings show a two-way relationship between bank risk and market discipline. In particular, market discipline has a negative impact on bank risk, while there is a positive relationship between bank risk and market discipline. A bidirectional relationship between them still holds when using an alternative measure of bank risk in subsamples, controlling for the global financial crisis and governance indicators.Practical implicationsThe findings indicate that market discipline can reduce bank risk. Meanwhile, a positive impact of bank risk on market discipline reemphasizes that market discipline is a powerful tool to ensure banks do not have excessive risk-taking. Nonetheless, the findings suggest that further implementation of market discipline as the third pillar of the Basel framework is necessary for the banking systems in ASEAN-5.Originality/valueTo the best of the authors’ knowledge, this study is the first attempt to investigate the interrelationship between bank risk and market discipline in Southeast Asia.

CEO POWER AND RISK-TAKING: INTERMEDIATE ROLE OF PERSONALITY TRAITS

In our paper we discuss how different personal characteristics of a CEO, being affected by CEO power, may in turn affect personal risk-taking. Agency theory states that managers have non-changing risk preferences and are either risk-averse or risk-neutral. In contrast to that, there may be cases, when managers are risk-seekers and power of executives is positively related to excessive risk-taking. Additionally, agency theory assumes that CEOs are homogenous in power use and ignores difference of CEOs in term of personality traits as well as its impact on corporate decisions. Therefore, our aim is to focus specifically on factors that connect CEO power with CEO risk-taking and to analyze possible effects of that relationship on firm. Based on both psychological and managerial studies, we conclude that, on the one hand, CEO’s power can affect CEO’s personal traits by producing [in the case of overconfidence or hubris] or by enhancing them [in case of narcissism]. On the other hand, CEO’s personal traits affect CEO’s risk-taking. It can be either by changing the perception of risk or because of behavior patterns inherent to those traits. Finally, we hypothesize that CEO power can affect CEO personal risk-taking through personality traits. By examining relationship between CEO power and CEO risk-taking based on individual-level determinants, our paper adds to the behavioral corporate finance and corporate governance literature.

Does the market discipline banks? Evidence from Balkan states

PurposeThis research is designed to investigate the presence of market discipline in the banking sector, across Balkan states in Europe. Specifically, the effects of CAMEL variables on the cost of funds and deposit-switching have been assessed.Design/methodology/approachThe CAMEL method of bank evaluation has been applied as well as two measures for market discipline (costs of funds and deposit-switching behaviour). Data have been obtained for 10 Balkan states for the 2006–2019 period. For data analysis, ordinary least squares (OLS) and fixed effects models have been utilized. The generalized method of moments (GMM) method has been deployed as well as a dynamic panel model.FindingsEvidence of market discipline has been found, in the form of a higher cost of funds in the context of capital adequacy (but not for other CAMEL variables). Evidence of market discipline in the form of deposit-switching, however, has not been found. In addition, it has been discovered that bank size and gross domestic product (GDP) growth lower the costs of funds for banks.Originality/valueIn the wake of the pandemic, banks need to prepare themselves for very difficult situations and relevant studies can provide help. Therefore, this research has contributed to the developing literature on this topic. In addition, the findings have important practical implications. Results show that banks should maintain adequate levels of capital if they want to control their costs of funds. Results also show that market discipline, in the form of higher costs of funds, can be imposed on banks to discourage excessive risk-taking. Findings highlight the value of appropriate policies and strong supervision of the financial industry. Findings also underline the importance of offering financial incentives to banks. For example, if banks know they will be able to avoid higher costs of funds by controlling their risk levels, they will avoid unrestrained risk-taking.

The Dollar as a Mutual Problem: New Transatlantic Interdependence in Finance

When the 2007 global financial crisis hit financial markets, European leaders were quick to point the finger at US markets, excessive risk-taking, and insufficient regulation. However, it soon became apparent that European banks were more exposed than their Wall Street counterparts. With massive dollar liabilities, European banks were dependent on the US to act as a global lender of last resort. The crisis revealed a level of transatlantic interdependence that had been unknown to most observers and policymakers prior to the crisis. We argue that this represents a paradox, given that the project of the European Monetary Union was partly motivated by a desire to make Europe more independent from the US dollar. The euro was a response to the challenge of “it’s our dollar, but it’s your problem.” In this article, we examine how the European vulnerability to the US dollar that began post-Bretton Woods did not, in fact, disappear with the creation of a European currency. Instead, through financialization and deregulation, European financial markets developed new, complex interactions with US financial markets. This financialization of transatlantic banking flows created a new type of interdependence. As European banks were so heavily invested in US markets, this gave the US authorities a direct interest in bailing them out. While cross-border banking flows have decreased since the crisis, the interdependencies remain, and currency swaps were used once again to handle the economic fallout from Covid-19. In the area of financial and monetary policy, the transatlantic relationship remains strong and stable within a dollar hegemony.

The Good, the Bad, and the Missed Boom

Abstract Some credit booms result in financial crises. While excessive risk-taking could plausibly explain the boom-to-bust cycle, many investors do not anticipate increasing risk. We show that credit booms may be misunderstood as being driven by high productivity because opaque bank assets disguise risk incentives. Balanced funding relative to productive prospects can sustain prudent lending (good boom), whereas funding imbalances may induce high risk exposure and boost asset prices (bad boom) or lead to asset underpricing and insufficient lending (missed boom). Rational agents drawing inference from prices make mistakes that can amplify the effect of funding imbalances and propagate risk. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

DO ISLAMIC BANKS IN INDONESIA TAKE EXCESSIVE RISK IN THEIR FINANCING ACTIVITIES?

This study analyzes the risk-taking behavior of Indonesian Islamic Banks by examining whether the relation between financing Growth rate and non-performing financing (NPF). We employ threshold regression models and bank-level data of 24 Islamic banks (full-fledged Islamic banks and Islamic banking windows) covering the period from 2009 to 2019. We find evidence for the excessive risk-taking of Islamic Banks. More specifically, while the relation between NPF and FGR is negative when the one-lagged NPF is below the threshold (estimated to be 5.42%), it turns positive once it is above the threshold. This means that banks with NPF above the 5.42 percent threshold tend to take risky loans.

Executive compensation linked to corporate social responsibility and firm risk

PurposeThe purpose of this study is to empirically examine the relationship between executive compensation linked to corporate social responsibility (CSR) and firm risk. It also explores the moderating role of CSR-linked compensation on the relationship between risk-taking incentives provided in executive compensation and firm risk.Design/methodology/approachThis study uses Ordinary Least Squares (OLS) and firm-fixed effects regressions to estimate the association between CSR-linked compensation and firm risk. Furthermore, it employs instrumental variable, propensity score matching and first-order difference approaches to address concerns about endogeneity and sample selection.FindingsBenchmark results show that CSR-linked compensation reduces both total and idiosyncratic measures of risk. Further results indicate that CSR-linked compensation reduces firm risk only when risk is above the optimal level and has no significant effect when risk is below the optimal level. Additionally, tests show that CSR-linked compensation also mitigates the positive effect of Vega of executive compensation on risk and this mitigation effect is significant only when risk is above the optimal level.Practical implicationsThe empirical results of this study show that boards can use CSR-linked compensation not only to induce higher social performance but also as a risk management tool to manage risk, especially when risk is above value increasing optimal levels. Furthermore, boards can use CSR-linked compensation to mitigate excessive risk-taking induced by option compensation.Originality/valueThis study contributes to the emerging literature on CSR-linked compensation and firm risk. To our knowledge, this is the first study that documents the direct risk-reducing effect of CSR-linked compensation and its mitigating effect on the relation between Vega of executive compensation and firm risk.

Personal characteristics and risk tolerance in a natural experiment

PurposeThis paper examines students' decisions when playing an in-class version of the TV game, Deal or No Deal (DOND), to study the relation between personal characteristics and individual decision-making under risk.Design/methodology/approachThis study analyzes DOND game play data collected from 374 students in 13 university finance classes, and their personal characteristics collected in a post-game survey. It uses ordered probit, OLS and probit regression analysis to examine the impact of personal characteristics on an individual's risk tolerance.FindingsThe key finding is that international students are significantly more risk averse than US domestic students. Additionally, given the natural control for age and education, the study finds that gender, race and religion have a limited impact on an individual's risk tolerance. Finally, the study provides evidence that the structure of the DOND game, in general, rewards risk-taking as long as it is not excessive. Once participant behavior becomes risk-seeking, the correlation between risk-taking and game payoff becomes negative.Research limitations/implicationsThe homogeneous set of contestants (business students) analyzed in this study presents some limitations yet provides opportunities to examine risk tolerance differences between the US and international students, and whether gender, race or religious affiliation has an impact on the level of risk tolerance given a natural control for age and education level.Practical implicationsThe evidence suggests that culture and environmental unfamiliarity may impact an individual's risk tolerance. This finding is useful when providing financial advice to diverse clients or when conducting international business. Additionally, understanding that education and financial literacy reduces differences in risk tolerance across gender, race and religion can impact the way we interact with others. A broader practical implication for all investors is that, while under normal circumstances, risk-taking is rewarded with a higher expected return, excessive risk-taking may harm their investment performance.Originality/valueThis paper utilizes a unique data set, collected through a class activity and post-class survey. While there have been empirical studies using DOND data, this is the first study that examines the impact of personal characteristics on game participants' behavior, thereby generating unique findings not reported in previous studies employing DOND data.