On risk, leverage and banks: do highly leveraged banks take on excessive risk?

This paper deals with the relation between excessive risk taking and capital structure in banks. Examining a quarterly dataset of U.S. banks between 1993 and 2010, we find that equity is valued higher when more risky portfolios are chosen when leverage is high, and that more risk taking has a negative impact on valuation of the debt of highly leveraged banks. We find no evidence that deposit insurance is encouraging risk taking behaviour. We do find that banks with a more troubled loan portfolio take on more risk. Banks whose share price has slumped tend to gamble for resurrection by increasing the riskiness of their asset portfolios. The results suggest that incentives embedded in the capital structure of banks contribute to systemic fragility, and so support the Basel III proposals towards less leverage and higher loss absorption capacity of capital.