The conventional wisdom is that well-capitalized banks are less inclined to increase asset risk, because the option value of deposit insurance decreases with capitalization. There are, however, at least three shortcomings in the existing theories that cast doubt on the validity of the conventional wisdom. First, many studies neglect agency problems arising from the separation of management and ownership. Second, past studies rely on limited risk-return profiles of the asset choice set and do not consider profiles in which higher risk is associated with higher return. Finally, empirical studies on this issue provide only mixed evidence. The aim of this paper is to shed new light on this issue by expanding existing models to account for the shortcomings identified. Thus, it explicitly models three different incentives of the agents that shape the risk-taking behavior in banking, regulatory bodies, shareholders, and management. The paper considers how the respective incentives influence the riskiness of a bank portfolio for four distinct assumptions about the characteristics of risk-return profiles. As a result it is demonstrated that a bank's risk can either decrease or increase with capitalization. The paper empirically demonstrates the differences in risk-capitalization relationships across high and low capital banks and across publicly and non-publicly traded banks, indicating that risk-capitalization relationships are, indeed, sensitive to the relative forces of the three agents in determining asset risk.
The banking literature has established two important results about the agency problem of the shareholder vis-à-vis the deposit insurer. First, when deposit insurance is underpriced, there exists a positive option value of insurance. Since the option value increases with asset risk (Merton, 1977), a bank interested in maximizing the equity value has an incentive to take excessive risks to exploit this option value (Kareken and Wallace, 1978; Sharpe, 1978; and Dothan and Williams, 1980). Second, since the option value increases with the leverage ratio, relatively well-capitalized banks will be less inclined to increase the asset risk (Keeley and Furlong, 1989 and 1990).