The banking firm and risk taking in a two-moment decision model ☆ Udo Broll a, ⁎, Xu Guo b , Peter Welzel c , Wing-Keung Wong d a Technische Universität Dresden, Germany b Nanjing Aeronautics and Astronautics University, China c University of Augsburg, Germany d Hong Kong Baptist University, Hong Kong abstract article info Article history: Accepted 24 June 2015 Available online xxxx JEL classification: D01 D81 G11 G21 Keywords: Risk taking Banking firm Elasticity of risk aversion Preferences We analyze a bank's risk taking in a two-moment decision framework. Our approach offers desirable properties like simplicity, intuitive interpretation, and empirical applicability. The bank's optimal behavior to a change in the standard deviation or the expected value of the risky asset's or portfolio's return can be described in terms of risk aversion elasticities, i.e., the sensitivity of the marginal rate of substitution between risk and return. The bank's investment in a risky asset position goes down when the return risk increases, if and only if the risk aversion elas- ticity exceeds −1. © 2015 Elsevier B.V. All rights reserved. 1. Introduction 1.1. Risk taking Financial risks are at the core of financial intermediation. Banks tak- ing deposits and holding portfolios of loans and other financial contracts need to manage liquidity risk, credit risk, market risk, and operational risk. Recently, the banking crisis has contributed to a wide-spread per- ception that banks do not always handle their risks sufficiently well, cre- ating damage for themselves and for the economy. In particular, they may be taking too high risks (see, for example, Admati and Hellwig, 2013). Regulators worldwide reacted in the Basel III framework e.g., by requiring banks to hold more equity and more liquidity. We are interested in the fundamental economics of risk taking by banks, i.e., how the distribution of returns shapes investment decisions. Our analysis shows that an increase in risk creates a substitution and an income effect which together may induce a risk averse bank decision maker to invest more in risky assets. For this result we need no separa- tion of ownership and control. The effect of incentive contracts written by bank owners for their managers or of strategic delegation in bank ol- igopolies which may also explain risk taking behavior will not be considered. 1.2. Related work and contribution of the paper Management of risk is an important topic in many fields of econom- ics, insurance, banking, and finance (see, for example, Baker and Filberg, 2015). In the economics of banking and finance, the question of how fi- nancial intermediaries react to changes in random and non-random pa- rameters of their market environment has a long tradition. Most of the literature makes use of the expected utility approach (see, for example, Wong, 1997; Freixas and Rochet, 2008; Broll et al., 2015). To characterize attitudes towards risk several concepts of risk aversion were introduced, such as prudence, standard risk aversion, risk vulnerability, temperance and shifts in first-order stochastic dominance (see Eeckhoudt et al., 1996 Wagener, 2002; Battermann et al., 2008; Chateauneuf and Lakhnati, 2015). However, the two-moment decision model which is based on the utility of the expected value and of the standard deviation of some uncertain monetary outcome offers an alter- native technique to analyze investment decisions. Although the mean– standard deviation model is sometimes regarded a special case of the expected utility approach, the two are distinct models of decision mak- ing under risk. Meyer (1987) shows that if all prospects to be ranked are equal in distribution, except for scale (standard deviation) and location (expected value), then any expected utility ranking of all prospects can Economic Modelling 50 (2015) 275–280 ☆ We would like to thank our anonymous referees, Paresh Narajan (editor of this journal), and participants of the research seminar at WHU (Otto Beisheim Graduate School of Management), in particular Achim Czerny and Peter-J. Jost, for the very helpful comments and suggestions. ⁎ Corresponding author at: Department of Business and Economics, School of International Studies (ZIS), Technische Universität Dresden, 01062 Dresden, Germany. E-mail address: udo.broll@tu-dresden.de (U. Broll). http://dx.doi.org/10.1016/j.econmod.2015.06.016 0264-9993/© 2015 Elsevier B.V. All rights reserved. Contents lists available at ScienceDirect Economic Modelling journal homepage: www.elsevier.com/locate/ecmod