RISK-TAKING BEHAVIOR OF BANKS UNDER REGULATION

This paper analyzes the value maximization of regulated banks within a moral-hazard framework. In the model, regulators monitor both the cap ital ratio and the asset portfolio, and banks simultaneously select th e optimum capital ratio and asset portfolio. A key assumption is that a bank cannot expect a positive put option value once it is classified as risky by regulators. The optimum values of the two variables depen d on investment opportunities and charter values, as well as regulator y parameters. The model that explicitly incorporates regulation can ex plain various phenomena that are seemingly inconsistent with the predi ctions of moral hazard models - for example, a positive relationship b etween the capital ratio and the riskiness of the asset portfolio. A p articularly interesting result is that a larger charter value results in a higher-risk interior solution.