Bank Risk Dynamics Where Assets are Risky Debt Claims
Author | Alon Raviv,Sharon Peleg‐Lazar |
DOI | http://doi.org/10.1111/eufm.12102 |
Published date | 01 January 2017 |
Date | 01 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
E-mail: sharonp5@post.tau.ac.il
Alon Raviv
Bar Ilan University, Ramat Gan, Israel
E-mail: Alon.Raviv@biu.ac.il
Abstract
The structuralapproach views firm’s 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 financial distress.
Furthermore, riskshifting increases with bankruptcy costs and decreaseswith bank
capital. Thus, increasing a bank’s 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 firm’s assets.
1
In this framework, since
the value of a firm’s stock, which is equivalent to a call option, is positively related to the
underlying asset’s 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.
1
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 firm’s assets, with a strike price equal to the
face value of its debt. Similarly, a firm’s stock is economically equivalent to a call option on
the value of the firm’s assets with a strike price equal to the face value of its debt.
European Financial Management, Vol. 23, No. 1, 2017, 3–31
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
financial 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 creditors’ability to limit risk
shifting is more restricted in financial 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-financial firms; this makes bank asset risk hard to observe and assess while
being easy to change and manipulate.
2
In a recent paper, Nagel and Purnanandam (2015) claimed that, since bank’s assets are
risky loans, their value is capped.
3
Therefore the value of the bank’s stock is not
equivalent to a call option on its asset as implied by the basic structural approach. Instead,
a bank’s assets are contingent claims on the value of their debtors’assets (see Figure 1).
Thus, bank equity is economically equivalent to an ‘option-on-option’with a payoff
function identical to that of subordinated debt, which can be replicated by a ‘bull spread’
strategy (Black and Cox, 1976).
4
Moreover, since bank assets are risky debt claims with
limited upside, asset volatility depends on the debtor’s asset value. Consequently, when
assuming that bank assets follow a log-normal stochastic process with a constant
Fig. 1. The value of the bank’s asset, debt and equity at debt maturity
The values in the figure 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 financed with equity and a single bond with a face value
of 60 that matures in one year.
2
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-financial firms suggesting that banks tend to be more opaque than non-
financial firms.
3
A similar analysis was suggested earlier by Dermine and Lajeri (2001).
4
This strategy consists of a long position in a call option on the corporation’s asset value, with
a strike price equal to the face value of the bank’s debt and a short position in a call option on
the corporation’s asset value, with a strike price equal to the face value of the debtor’s debt.
© 2016 John Wiley & Sons, Ltd.
4Sharon Peleg-Lazar and Alon Raviv
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