Bank portfolio management and regulatory policies

Pelizzon, L (2002) Bank portfolio management and regulatory policies. Doctoral thesis, University of London: London Business School.

Abstract

This Thesis investigates the impact of different regulatory instruments on bank portfolio and on the probability of default and the value of deposit insurance. A central assumption in our analysis is that the bank's owners are risk neutral, enjoy limited liability and may (i) replenish capital, (ii) dynamically manage the investment portfolio and (iii) earn rents from a number of sources. In particular, we consider rents derived from: (i) underpriced deposit insurance, (ii) super-normal returns on loans, and (iii) imperfect competition in the market for deposits so that the bank may attract deposits at a cost lower than the risk-free interest rate. The Thesis comprises six chapters. Chapter 1 describes the focus and purpose of the Thesis. Chapter 2 presents the basic model and shows that corner solutions do not always characterize optimal portfolio choice and that the latter is strongly affected by the sources of rent. These results contrast with those of previous studies that have considered the effects of the franchise value on bank risk taking behavior. Chapter 2 also examines shareholders' incentive to recapitalize when the bank is solvent but is loss making and how the cost of capital may affect portfolio decisions. Chapter 3 studies the effects of different sources of rent in conjunction with (i) capital adequacy regulation and (ii) closure rules. Again, the results show that the sources of rent strongly influence the effects of regulatory mechanisms on portfolio choice, the probability of default and the value of deposit insurance. Chapters 4 and 5 extend the base model of Chapter 2 to the case where the bank may modify its portfolio composition between audit times. In the former we consider audit times to be fixed while in the latter audits occur randomly. The two main issues that we analyze in these Chapters are dynamic portfolio strategies and the intertemporal effect of capital requirements. Our results suggest that regulators must carefully take into consideration the consequences of banks' ability to revise their portfolios dynamically because the increase of the franchise value is generated partly at the expense of the deposit insurer. Moreover, the intertemporal effect of capital requirements may induce the bank to choose strategies with a probability of default and value of deposit insurance higher than in the case without capital requirements. Chapter 6 presents conclusions and recommendations for further researches.