Bank Profitability and Risk-Taking

IMF Working Papers, November 25, 2015

Source details

Traditional theory suggests that more profitable banks should have lower risk-taking incentives.
The paper asks: why did many profitable banks choose to invest in untested financial instruments before the crisis, realizing significant losses?
Conclusion: a more profitable core business can allow a bank to borrow more and take side risks on a larger scale, potentially increasing overall risk-taking incentives despite lower marginal incentives for a given size of risk.

Banks are endowed with a fixed core business.
Banks 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:
- increases a bank’s ability to borrow;
- enables taking side risks on a larger scale;
- offsets the lower incentives to take risk of a given size, leading to potentially higher aggregate risk-taking.

The framework can reconcile theory and observed behavior of banks in the run up to the recent financial crisis.
The model is consistent with cross-sectional patterns of bank risk-taking observed before the crisis.

Subject: Accommodative monetary policy; Bank soundness; Banking; Financial crises; Financial institutions; Financial sector policy and analysis; Financial services; Investment banking; Monetary policy; Stocks; Tax incentives
Keywords: Accommodative monetary policy; Bank Capital; Bank soundness; Banks; Crises; Global; interest rate; Investment banking; investment X; market-based investment; monetary policy; project investment; Repo Markets; Risk-Taking; risky investment; side investment; Stocks; WP