Bank Profitability and Risk-Taking

Traditional theory suggests that more profitable banks have lower risk-taking incentives. Then why did many profitable banks make risky investments before the crisis, realizing substantial losses? We attempt to reconcile theory and evidence. In our setup, banks are endowed with a core business, and can borrow to make risky investments alongside it. A more profitable core business enables a bank to borrow more and take risk on a larger scale, offsetting lower incentives to take risk of fixed size. Therefore, more profitable banks may have higher risk-taking incentives. The framework offers implications for financial regulation and monetary policy.