Impact of charter values on moral hazard in banking

Marcus (1984) model posits that the charter value acts as a buffer to the risk taking behavior predicted by the Merton (1977) option based model. The traditional charter value hypothesis establishes the inverse relationship between the charter value and bank risk taking giving a rise to the so-called disciplinary role of bank charter value (Keeley, 1990). Unprecedented government assistance programs to the banking industry that followed the 2008 financial crisis renewed interest in the risk taking incentives and moral hazard effects of the government safety net. Despite its importance, the question about the disciplining effect of bank charter values and impact of government bailouts on bank risk taking has not received a definitive answer in recent literature. In my dissertation, I directly test the impact of charter value on equity vega within the option based framework using a sample of U.S. based depository institutions from 1995 to 2012.;My dissertation makes several contributions to the literature. First, using simulations of Marcus (1984) model, I demonstrate that the relationship between charter value and risk taking is non-monotonic and is dependent on business cycles and interest rate regimes. Second, using several alternative proxies of charter values, I empirically confirm a non-monotonic relationship between the charter value and equity vega. I show that the charter value plays a disciplinary role only for institutions with high charter values while the opposite is true for the institutions with low charter values. My findings call into question the traditional charter value hypothesis. Third, I introduce the impact of bailouts using simulation and then empirically test my hypotheses of the effects of the Troubled Assets Relief Program (TARP) on the disciplining role of charter value. For the first time in the literature, using option based framework, I show that the impact of TARP on bank risk taking is non-monotonic: it increases risk taking incentives for the TARP recipients relative to non-recipients for institutions with low charter values, while the opposite is true for institutions with high charter values.