The Risk Spiral: The Effects of Bank Capital and Diversification on Risk Taking

We present a model where bank assets are a portfolio of risky debt claims and analyze equityholders' risk-taking behavior while considering the strategic interaction between debtors and creditors. We find that: (1) as the... [ view full abstract ]

We present a model where bank assets are a portfolio of risky debt claims and analyze equityholders' 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 comovement of a loan portfolio increases the bank's cost of default directly, we find that the increase prevails through a second channel: an increase in risk shifting. (3) Risk shifting decreases with the diversification of a loan portfolio.