This paper examines two qualitative rules of thumb, frequently invoked in discussions of
bank regulatory policy. The first, that equity holders prefer more risk to less, derives from
a result in option pricing theory, that an option’s value increases monotonically with the
riskiness of the underlying asset. This result is shown to depend on very restrictive
assumptions regarding the underlying assets return distribution and the type of option
being considered. These restrictive assumptions do not generally obtain in practice. The
second rule of thumb is that bondholders’ and deposit insurers’ interests are aligned. The
paper shows that, in fact, their interests can diverge in the sense that bondholders and
deposit insurers will not necessarily agree on the relative riskiness of different banks or
bank portfolios. The conclusion of this paper is that rules of thumb can be misleading.
Furthermore, the concept of risk is shown to be model and agent specific.