The impact of write-down equity on bank stability under ambiguity aversion

Abstract

This study quantifies the impact of write-down equity (WDE) on bank stability and risk-taking incentives under ambiguity aversion. We decompose payoffs to bank stakeholders into sets of barrier options and present closed-form solutions for their prices. Our paper shows that: first, write-down equity plays an important role in eliminating managerial risk-taking incentives: a 1% increase in write-down ratio reduces the managerial optimal risk level by 0.2%. Second, WDE has double effect of equity incentives and penalties. With low leverage ratio, risk-taking incentives dominate while the write-down ratio falls below 0.51. Third, ambiguity-averse managers are more conservative resulting in lower banking default probability. Meanwhile, as ambiguity increasing policy makers should implement a higher write-down ratio to stabilize banks.