Bank Risk Dynamics Where Assets are Risky Debt Claims

AuthorAlon Raviv,Sharon Peleg‐Lazar
Publication Date01 January 2017
Date01 January 2017
Bank Risk Dynamics Where Assets are
Risky Debt Claims
Sharon Peleg-Lazar
The Leon Recanati Graduate School of Business Administration, Tel Aviv University, Israel
Alon Raviv
Bar Ilan University, Ramat Gan, Israel
The structuralapproach views rms equity as a call option on the value of its assets,
which motivates stockholders to increase risk. However,since bank assets are risky
debt claims, bankequity resembles a subordinated debt. Using thisassumption, and
considering the strategic interaction between a bank and its debtor, we argue that
risk shifting is limited to states in which the debtor is in nancial distress.
Furthermore, riskshifting increases with bankruptcy costs and decreaseswith bank
capital. Thus, increasing a banks capital affects stability, not only through the
additional capital buffer, but also by affecting the risk shifting incentive.
Keywords: risk taking, asset risk, financial institutions, stress test, leverage
JEL classification: G21, G28, G32, G38
1. Introduction
The structural approach for pricing corporate liabilities, developed by Merton (1974),
views debt and equity as contingent claims on the rms assets.
In this framework, since
the value of a rms stock, which is equivalent to a call option, is positively related to the
underlying assets volatility, a stockholder aligned manager would be motivated to
The authors thank Dan Galai, Michel Crouhy, Zvi Wiener, Menachem Abudy, Beni
Lauterbach and Linda Allen as well as the participants in the International Finance And
Banking Society (IFABS) 2016 Conference and the International Risk Management
Conference (IRMC) 2016 for useful comments. Raviv acknowledges the financial support
of this study by the Israel Science Foundation (ISF) through grant number 969/15.
A risky corporate bond is economically equivalent to a long position in a risk-free bond and
a short position in a European put option on the rms assets, with a strike price equal to the
face value of its debt. Similarly, a rms stock is economically equivalent to a call option on
the value of the rms assets with a strike price equal to the face value of its debt.
European Financial Management, Vol. 23, No. 1, 2017, 331
doi: 10.1111/eufm.12102
© 2016 John Wiley & Sons, Ltd.
increase asset risk (Galai and Masulis, 1976; and Jensen and Meckling, 1976). However,
rational creditors will consider these incentives when determining credit conditions. The
nancial literature suggests that banks are especially good at setting credit conditions and
covenants, and monitoring their borrowers to limit risk shifting (Brealey et al., 1977;
Campbell and Kracaw, 1980; Diamond, 1984; and Fama, 1985).
In contrast, empirical and theoretical work suggests that creditorsability to limit risk
shifting is more restricted in nancial institutions as creditors are small and dispersed and
bondholders may have explicit (deposit insurance) or implicit (too big to fail) guaranties.
Moreover, banks are more complex and opaque with greater information asymmetries
than non-nancial rms; this makes bank asset risk hard to observe and assess while
being easy to change and manipulate.
In a recent paper, Nagel and Purnanandam (2015) claimed that, since banks assets are
risky loans, their value is capped.
Therefore the value of the banks stock is not
equivalent to a call option on its asset as implied by the basic structural approach. Instead,
a banks assets are contingent claims on the value of their debtorsassets (see Figure 1).
Thus, bank equity is economically equivalent to an option-on-optionwith a payoff
function identical to that of subordinated debt, which can be replicated by a bull spread
strategy (Black and Cox, 1976).
Moreover, since bank assets are risky debt claims with
limited upside, asset volatility depends on the debtors asset value. Consequently, when
assuming that bank assets follow a log-normal stochastic process with a constant
Fig. 1. The value of the banks asset, debt and equity at debt maturity
The values in the gure refer to a bank with a single asset a corporate loan with a face value of 80
and time to maturity of one year. The bank is nanced with equity and a single bond with a face value
of 60 that matures in one year.
Caprio and Levine (2002) discussed the corporate governance of banks and their
opaqueness. Morgan (2000) found that bond analysts disagree more over bonds issued by
banks than by non-nancial rms suggesting that banks tend to be more opaque than non-
nancial rms.
A similar analysis was suggested earlier by Dermine and Lajeri (2001).
This strategy consists of a long position in a call option on the corporations asset value, with
a strike price equal to the face value of the banks debt and a short position in a call option on
the corporations asset value, with a strike price equal to the face value of the debtors debt.
© 2016 John Wiley & Sons, Ltd.
4Sharon Peleg-Lazar and Alon Raviv

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