Bank capital and Risk-Taking: Old and New Perspectives from the Crisis

The objective of this article is to provide a review of the prolific literature that came out of the crisis on the specific question of bank capital and risk-taking. The way financial leverage can induce risk-taking is well understood in finance. Banks are special in regard to this issue, given their high leverage and the existence of deposit insurance and bailout guarantees. The evolution of banks, which are far more intertwined with the capital markets than they used to, considerably reinforced their ability to take risk. The crisis provided a wonderful experiment to highlight the importance of those specificities of banks in regard to their leverage and risk-taking. It also offered new perspectives on the question, notably the mechanisms of collective risk-taking and procyclicity of leverage. The way the regulation of bank capital was designed holds an important responsibility in fostering a very fragile business model of banks. At last, the performance measurement in banks and the compensation policy played a decisive role in encouraging financial leverage and risk-taking.
Keywords: Bank Capital; Risk-Taking; Capital Regulation; Leverage; Deposit Insurance; Bailout; CEO Compensation; Financial Crisis.
JEL codes: G01, G21, G28, G32, J33