The risk spiral: The effects of bank capital and diversification on risk taking

Abstract

We present a model where bank assets are a portfolio of risky debt claims and analyze stockholders' risk-taking behavior while considering the strategic interaction between debtors and creditors. We find that: (1) as the leverage of a bank increases, risk shifting by borrowers increases, even if their leverage is unchanged (zombie lending). (2) While the literature demonstrates that an increase in the co-movement of a loan portfolio increases the bank's cost of default directly, we find that the increase in co-movement causes an increase in risk shifting that further increases the cost of default (3) Risk shifting decreases with the diversification of a loan portfolio.