Caught between Scylla and Charybdis? Regulating Bank Leverage When There is Rent Seeking and Risk Shifting
Viral V. Acharya
New York University - Leonard N. Stern School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); New York University (NYU) - Department of Finance
Federal Reserve Bank of New York
Anjan V. Thakor
Washington University, Saint Louis - John M. Olin School of Business; European Corporate Governance Institute (ECGI)
September 11, 2015
AFA 2012 Chicago Meetings Paper
European Corporate Governance Institute (ECGI) - Finance Working Paper No. 365/2013
We develop a theory of optimal bank leverage in which the benefit of debt in inducing loan monitoring is balanced against the benefit of equity in attenuating risk-shifting. However, faced with socially-costly correlated bank failures, regulators bail out creditors. Anticipation of this generates multiple equilibria, including one with systemic risk in which banks use excessive leverage to fund correlated, inefficiently risky loans. Limiting leverage and resolving both moral hazards — insufficient loan monitoring and asset substitution — requires a novel two-tiered capital requirement, including a “special capital account” that is unavailable to creditors upon failure.
Number of Pages in PDF File: 54
Keywords: market discipline, asset substitution, systemic risk, bailout, forbearance, moral hazard, capital requirements
JEL Classification: G21, G28, G32, G35, G38
Date posted: March 15, 2011 ; Last revised: October 9, 2015
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