Working Paper: NBER ID: w19633
Authors: William Gornall; Ilya A. Strebulaev
Abstract: We develop a model of the joint capital structure decisions of banks and their borrowers. Strikingly high bank leverage emerges naturally from the interplay between two sets of forces. First, seniority and diversification reduce bank asset volatility by an order of magnitude relative to that of their borrowers. Second, previously unstudied supply chain effects mean that highly levered financial intermediaries are the most efficient. Low asset volatility enables banks to safely take on high leverage; supply chain effects compel them to do so. Firms with low leverage also arise naturally as borrowers internalize the systematic risk costs they impose on their lenders. Because risk assessment techniques from the Basel II framework underlie our structural model, we can quantify the impact capital regulation and other government interventions have on bank leverage, firm leverage, and fragility. Deposit insurance and the expectation of government bailouts lead not only to risk taking by banks, but increased risk taking by firms. Capital regulation lowers bank leverage but can lead to compensating increases in the leverage of firms, as well as a small increase in borrowing costs.
Keywords: No keywords provided
JEL Codes: G01; G18; G2; G21; G28; G32; G38
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| systematic risk costs that firms impose on banks (G21) | banks prefer lower leverage in their borrowers (G21) |
| capital regulation (G28) | may inadvertently increase firm leverage (G32) |
| capital regulation that fails to account for borrower risk (G21) | banks lend to riskier firms (G21) |
| banks with high levels of insured deposits (G28) | exhibit greater leverage and riskier lending practices (G21) |
| interplay between seniority and diversification (J62) | bank asset volatility (E44) |
| seniority and diversification significantly reduce bank asset volatility compared to that of borrowers (G51) | banks can safely take on high leverage while maintaining low default risk (G21) |