Caught between Scylla and Charybdis? Regulating Bank Leverage When There is Rent Seeking and Risk Shifting
Federal Reserve Bank of New York
Viral V. Acharya
New York University - Leonard N. Stern School of Business; Centre for International Finance and Regulation (CIFR); Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); New York University (NYU) - Department of Finance
Anjan V. Thakor
Washington University, Saint Louis - John M. Olin School of Business; European Corporate Governance Institute (ECGI)
ECGI - Finance Working Paper No. 365/2013
AFA 2012 Chicago Meetings Paper
Banks face two moral hazard problems: asset substitution by shareholders (e.g., making risky, negative net present value loans) and managerial rent seeking (e.g., investing in inefficient “pet” projects or simply being lazy and un-innovative). The privately-optimal level of bank leverage is neither too low nor too high: It balances efficiently the market discipline imposed by owners of risky debt on managerial rent-seeking against the asset-substitution induced at high levels of leverage. However, when correlated bank failures can impose significant social costs, regulators may bail out bank creditors. Anticipation of this generates an equilibrium featuring systemic risk in which all banks choose inefficiently high leverage to fund correlated assets. A minimum equity capital requirement can rule out asset substitution but also compromises market discipline by making bank debt too safe. The optimal capital regulation requires that a part of bank capital be unavailable to creditors upon failure, and be available to shareholders only contingent on good performance.
Number of Pages in PDF File: 53
Keywords: Market Discipline, Asset Substitution, Systemic Risk, Dailout, Forbearance, Moral Hazard, Capital Requirements
JEL Classification: G21, G28, G32, G35, G38Accepted Paper Series
Date posted: March 15, 2011 ; Last revised: June 27, 2013
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