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In moral hazard models, bank shareholders have incentives to transfer wealth from the deposit insurer – that is, maximize put option value – by pursuing riskier strategies. For safe banks with large charter value, however, the risk-taking incentive is outweighed by the possibility of losing charter value. Focusing on the relationship between Tobin’s q and an ex ante measure of the failure probability, this paper develops a semi-parametric model for estimating the critical level of bank risk at which put option value starts outweighing charter value. From these estimates, we infer the prevalence of moral hazard. Examining publicly held bank holding companies (BHC) during the tumultuous 1986–1992 period, we find that shareholders’ risk-taking incentives were confined to a small fraction of highly risky institutions. Furthermore, our analysis shows that the inflection point at which banks begin to tilt in favor of moral hazard increased substantially in 1993–2005. These findings are encouraging to bank regulators and legislators because they indicate that tighter capital rules and more rigorous supervision introduced by several legislative initiatives in the 1990s have helped squeeze a lot of the moral hazard incentives out of the banking system.

Many regulators and academic researchers have emphasized market discipline as a means to improve the safety and soundness of the banking system. Perhaps this cannot be more pertinent than in today’s complex financial landscape. Because of ever increasing complexity of the banking business, it is difficult to effectively regulate banks solely based on prescribed rules. The importance of market discipline is underscored by several banking and financial crises experienced in the last two decades across several emerging markets as well as more industrialized countries worldwide. In many instances, the inability of bank regulators and market forces to effectively discipline financial institutions was deemed as the missing ingredient for ensuring financial stability.

This paper has empirically examined how the put option value and charter value of banks interact with risk. Our analysis reveals a distinct convex nonlinear relationship between the market-to-book ratio and bank risk. The paper’s theoretical framework attributes the observed convex relationship to bank shareholders’ disparate affinity for risk. Initially, shareholders penalize riskier strategies to preserve charter value. But once the option value becomes large enough to compensate for the loss of charter value, shareholders elect instead to reward risk-taking to further increase the put option value. The convex relationship between the q ratio and the likelihood of failure or default allows us to identify the threshold of risk at which the marginal benefit from the option value starts outweighing the expected loss of charter value. Our empirical results show that this risk turning point was quite high even during the turbulent period 1986–1992 and much higher in the recent period 1993–2005. We conclude, therefore, that for publicly held BHCs, the interests of bank shareholders are aligned with those of regulators and debtholders, except for a small subset of extremely risky ones.