How Important is Moral Hazard for Distressed Banks?

How Important is Moral Hazard for Distressed Banks?

Itzhak Ben-David, Ajay A. Palvia, René Stulz

Series number :

Serial Number: 
681/2020

Date posted :

May 25 2020

Last revised :

May 25 2020
SSRN Share

Keywords

  • Banks • 
  • Distress • 
  • debt overhang • 
  • deleveraging • 
  • leverage

The moral hazard incentives of the bank safety net predict that distressed banks take on more risk and higher leverage. Since many factors reduce these incentives, including charter value, regulation, and managerial incentives, the net economic effect of these incentives is an empirical question.

We provide evidence on this question using two distinct periods that include financial crises and are subject to different regulatory regimes (1985–1994, 2005–2014). We find that distressed banks reduce their leverage and decrease observable measures of riskiness, which is inconsistent with the view that, on average, moral hazard incentives dominate distressed bank leverage and risk-taking policies.
 

Authors

Real name:
Ajay A. Palvia
Real name:
Itzhak Ben-David