Growth Opportunities and Risk-Taking by Financial Intermediaries

Authors

  • RICHARD J. HERRING,

  • PRASHANT VANKUDRE

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    • Richard Herring is Professor of Finance at the Wharton School, University of Pennsylvania and Prashant Vankudre is Assistant Professor of Finance at the Graduate School of Business, Washington University of St. Louis. The authors are grateful to Franklin Allen, Mark Flannery, Jack Guttentag, and Anthony Santomero for comments on a previous draft.

ABSTRACT

We show that growth opportunities which cannot be converted to cash under conditions of financial distress (Gz) are a critical determinant of an intermediary's choice of risk. Financial institutions in which Gz is a low proportion of total assets will be much more likely to engage in go-for-broke behavior. The model leads to a reevaluation of the effectiveness of several traditional remedies for dealing with banks that take excessive risks such as raising insurance premiums, intervening before capital is depleted, and restricting investment options. The model also has implications about a new approach to the examination of financial intermediaries.

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