Nº 13-33: Capital Levels and Risk-Taking Propensity in Financial Institutions

Regulators dedicate much attention to the option that financial institutions in distress have to transfer losses to their creditors. It is generally recognized that the existence of this option provides intermediaries with a powerful incentive to keep firm capital close to the minimal requirement. We argue that undercapitalization however harms profitable growth opportunities. Our model quantifies the interaction of these incentives and derives implications for regulation.