Bank Profitability and Risk-Taking

Author/Editor:

Natalya Martynova ; Lev Ratnovski ; Razvan Vlahu

Publication Date:

November 25, 2015

Electronic Access:

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Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary:

Traditional theory suggests that more profitable banks should have lower risk-taking incentives. Then why did many profitable banks choose to invest in untested financial instruments before the crisis, realizing significant losses? We attempt to reconcile theory and evidence. In our setup, banks are endowed with a fixed core business. They take risk by levering up to engage in risky ‘side activities’(such as market-based investments) alongside the core business. A more profitable core business allows a bank to borrow more and take side risks on a larger scale, offsetting lower incentives to take risk of given size. Consequently, more profitable banks may have higher risk-taking incentives. The framework is consistent with cross-sectional patterns of bank risk-taking in the run up to the recent financial crisis.

Series:

Working Paper No. 15/249

Subject:

English

Publication Date:

November 25, 2015

ISBN/ISSN:

9781513517582/1018-5941

Stock No:

WPIEA2015249

Format:

Paper

Pages:

43

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