Real interest rates, leverage, and bank risk-taking (Q2434341)

In the present paper, the authors study a model of bank risk taking. In the case where all deposits are risk-sensitive, they show that, when an internal solution \(\widehat{k}\) for the capitalization ratio exists, then \(\widehat{k}\) will be increasing in the real interest rate \(r^*\); that is, \(\frac{d \widehat{k}}{d r^*} > 0\). Furthermore, they show that, when bank leverage is optimally chosen to maximize profits, monitoring will always increase with the real interest rate; that is, \(\frac{d \widehat{q}}{d r^*} > 0\), where \(\widehat{q}\) denotes the bank's equilibrium monitoring behaviour. When the leverage is exogenous, the authors show a similar result, namely that there exists a degree of capitalization \(0 \leq \widetilde{k} < 1\) such that for \(k \geq \widetilde{k}\) bank monitoring increases with the real interest rate; that is, \(\frac{d \widehat{q}}{d r^*} > 0\). Extensions of the model, a numerical example and some empirical evidence are presented as well.