Opaque Bank Assets and Optimal Equity Capital

Assoc Prof Jussi Keppo

National University of Singapore

About the Speaker

Jussi Keppo teaches risk management and business analytics courses.

He has several publications in the top-tier journals such as Journal of Economic Theory, Review of Economic Studies, and Journal of Business on topics such as investment analysis, information economics, and banking regulation. His research has been featured also in numerous business and popular publications, including the Wall Street Journal and Fortune.

His research has been supported by several Asian, European, and US agencies such as the National Science Foundation.

He serves on the editorial boards of Mathematics of Operations Research, Journal of Risk, Production and Operations Management, and Journal of Energy Markets. He has consulted several Fortune 100 and asset management companies.

Abstract

Banks' assets are opaque and, therefore, we model their accounting asset values as partially observed variables that have a static uncertainty term.

We derive a stochastic control model for this situation and calibrate that to a sample of U.S. banks. Under the calibrated model, the banks have incentive to add noise to the reported accounting asset values and smooth their asset values to hide their solvency risk from banking regulators. The partially observed model explains the banks' realized dividends and equity market values significantly better than the corresponding fully observed model, indicating that the banks consider the accounting noise and its benefits when optimizing their equity capital level. Further, due to the substantial shock on the asset values, the banks' assets were more opaque during the recent financial crisis than outside that.

This is a joint work with Min Dai and Shan Huang.