PUBLICATIONS
THE RISK SPIRAL: THE EFFECTS OF BANK CAPITAL AND DIVERSIFICATION ON RISK TAKING. INTERNATIONAL REVIEW OF FINANCIAL ANALYSIS, 65 (2019): 101388.
WITH ALON RAVIV
We present a model where bank assets are a portfolio of risky debt claims and analyze stockholders' risk-taking behavior while considering the strategic interaction between debtors and creditors. We find that: (1) as the leverage of a bank increases, risk shifting by borrowers increases, even if their leverage is unchanged (zombie lending). (2) While the literature demonstrates that an increase in comovement of a loan portfolio increases the bank's cost of default directly, we find that the increase prevails through a second channel: an increase in risk shifting. (3) Risk shifting decreases with the diversification of a loan portfolio.
A CLOSED-FORM SOLUTION TO THE RISK-TAKING MOTIVATION OF SUBORDINATED DEBTHOLDERS. ECONOMICS LETTERS, 181 (2019): 169-173.
WITH YUVAL HELLER AND ALON RAVIV.
Black and Cox (1976) claim that the value of junior debt is increasing in asset risk when the firm’s value is low. We show, using closed-form solution, that the junior debt’s value is hump-shaped. This has interesting implications for the market-discipline role of banks’ junior debt.
BANK RISK DYNAMICS WHERE ASSETS ARE RISKY DEBT CLAIMS. EUROPEAN FINANCIAL MANAGEMENT, EUROPEAN FINANCIAL MANAGEMENT 23.1 (2017): 3-31..
WITH ALON RAVIV.
The structural approach views firm's equity as a call option on the value of its assets, which motivates stockholders to increase risk. However, since bank assets are risky debt claims, bank equity resembles a subordinated debt. Using this assumption and considering the strategic interaction between a bank and its debtor, we argue that risk-shifting is limited to states in which the debtor is in financial distress. Furthermore, risk shifting increases with bankruptcy costs and decreases with bank capital. Thus, increasing a bank's capital affects stability, not only through the additional capital buffer, but also by affecting the risk shifting incentive.
WORKING PAPERS
DESIGNING BANKERS' PAY: USING CONTINGENT CAPITAL TO REDUCE RISK-SHIFTING INCENTIVES
WITH JENS HILSCHER AND ALON RAVIV
Including contingent convertible bonds (coco) in the capital structure of a bank affects the sensitivity to risk of its equity-based compensation. Such risk-shifting incentives can be reduced if the coco bonds are well-designed. Similarly, we show that compensating executives instead with well-designed coco bonds can also reduce risk-shifting incentives. In practice, however, most coco bonds have characteristics that result in both stock and coco compensation having large sensitivities to changes in asset risk -- equity-based compensation encourages executives to increase risk, coco compensation to reduce risk. We show that a pay package combining both stock and coco can practically eliminate risk-shifting incentives and that it can be implemented with a bank's preexisting coco bonds.
We analyze the influence of unsecured debt (subdebt) on risk-shifting in banks whose assets are risky debt claims. We assume that the stockholders and subdebtholders jointly decide on risk-shifting. We show that replacing part of the stock with subdebt: (1) leads to fewer risk-shifting events, but can lead to higher levels of risk, depending on the relative bargaining power, (2) does not change the level of risk shifting when side payments are possible, and (3) may yield the surprising result that risk-shifting increases with tighter regulatory control.
While it is clear that returns of financial assets are not well described by the normal distribution, it is unclear how best to describe them. One distribution suggested is the Pareto distribution. I apply an extreme value theory framework to estimate the tails of the distributions of returns of the TA25, the Tel-Aviv Stock Exchange's leading stock index and the USD-ILS exchange rate, under the assumption returns follow the Pareto distribution. I find that the left tail of the TA25 is lighter than that of the S&P500, suggesting less extreme events in the TA25 and the right tail of the USD-ILS exchange rate is heavier than the left tail, indicating that there are more extreme events when the ILS weakens against the USD than vice versa. This may be due to central bank intervention. I use the estimated tail indexes to assess the value-at-risk of the TA25 and USD-ILS and find the estimations fit historical values well for relatively high percentiles, which are most problematic to estimate.