Closure Rules, Market Power and Risk-Taking in a Dynamic Model of Bank Behaviour

Abstract

The value of bank charters is an important component of bankruptcy costs to bankers and may constitute an incentive for banks to adopt prudent decisions. Charter values had been considered as exogenous by previous researchers. Dynamic programming techniques allow us to obtain simultaneously the (endogenous) value of a bank and its optimal investment and financial policies. This model predicts a bang-bang risk-taking behaviour by banks which might explain the sudden appearance of solvency problems in the banking sector. Soft prudential regulation, low market power and a high risk-free interest rate may shift a bank from safe to risky. So, capital and asset regulations, and entry and closure rules are alternative ways to preserve solvency. Policy implications for the regulatory debate in the US and Europe are derived.

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