Working Paper: CEPR ID: DP9402
Authors: Hans Gersbach; Hans Haller; Jörg Müller
Abstract: We examine the validity of a macroeconomic version of the Modigliani-Miller theorem. For this purpose, we develop a general equilibrium model with two production sectors, risk-averse households and financial intermediation by banks. Banks are funded by deposits and (outside) equity and monitor borrowers in lending. We impose favorable manifestations of the underlying frictions and distortions. We obtain two classes of equilibria. In the first class, the debt-equity ratio of banks is low. The first-best allocation obtains and banks' capital structure is irrelevant for welfare: a macroeconomic version of the Modigliani-Miller theorem. However, there exists a second class of equilibria with high debt-equity ratios. Banks are larger and invest more in risky technologies. Default and bailouts financed by lump sum taxation occur with positive probability and welfare is lower. Imposing minimum equity capital requirements eliminates all inefficient equilibria and guarantees the global validity of the macroeconomic version of the Modigliani-Miller theorem.
Keywords: banking; capital requirements; capital structure; financial intermediation; general equilibrium; Modigliani-Miller
JEL Codes: D53; E44; G2
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| low debt-equity ratios (G32) | welfare (I38) |
| high debt-equity ratios (G32) | lower welfare (I38) |
| high debt-equity ratios (G32) | over-investment in risky technologies (G31) |
| over-investment in risky technologies (G31) | defaults (Y60) |
| defaults (Y60) | lower welfare (I38) |
| minimum equity capital requirements (G21) | eliminate inefficient equilibria (D50) |
| eliminate inefficient equilibria (D50) | restore validity of Modigliani-Miller theorem (G19) |