Bank Risk Dynamics Where Assets are Risky Debt Claims

Abstract

The structural approach 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, bank equity resembles a subordinated debt. Using this assumption, 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, risk shifting increases with bankruptcy costs and decreases with 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.

Do bond yields follow the hierarchy of risk post BRRD?

“…The actual impact of bail‐in depends on whether investors consider this mechanism a plausible threat to their savings (Lewrick et al, 2019). Financial prices will reflect the extent to which bail‐in is valued as a credible risk by the market (Peleg‐Lazar & Raviv, 2016). In the event of resolution, the actual severity of losses for bondholders via bail‐in depends on the specific type of securities issued by the bank.…”