The risk spiral: The effects of bank capital and diversification on risk taking

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 the comovement of a loan portfolio increases the bank's cost of default directly, we find that the increase in comovement causes an increase in risk shifting that further increases the cost of default (3) Risk shifting decreases with the diversification of a loan portfolio.