Working Paper: CEPR ID: DP4016
Authors: Hans Gersbach
Abstract: We examine the optimal allocation of equity and debt across banks and industrial firms when both are faced with incentive problems and firms borrow from banks. Increasing bank equity mitigates the bank-level moral hazard but may exacerbate the firm-level moral hazard due to the dilution of firm equity. Competition among banks does not result in a socially efficient level of equity. Imposing capital requirements on banks leads to the socially optimal capital structure of the economy in the sense of maximizing aggregate output. Such capital regulation is second-best and must balance three costs: excessive risk-taking of banks, credit restrictions banks impose on firms with low equity, and credit restrictions due to high loan interest rates.
Keywords: Bank Capital; Banking Regulation; Capital Structure of the Economy; Double Incentive Problems; Financial Intermediation
JEL Codes: D41; E40; G20
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increasing bank equity (G21) | Mitigates bank-level moral hazard (G21) |
| Increasing bank equity (G21) | Exacerbates firm-level moral hazard (G32) |
| Competition among banks (G21) | Suboptimal equity levels (D63) |
| Imposing capital requirements on banks (G28) | Socially optimal capital structure (G32) |
| Imposing capital requirements on banks (G28) | Maximizes aggregate output (E23) |