Liquid-Claim Production, Risk Management, and Bank Capital Structure: Why High Leverage is Optimal for Banks
University of Southern California - Marshall School of Business - Finance and Business Economics Department
Rene M. Stulz
Ohio State University (OSU) - Department of Finance; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)
February 17, 2014
Fisher College of Business Working Paper No. 2013-03-08
Charles A. Dice Center Working Paper No. 2013-8
ECGI - Finance Working Paper No. 356
Liquidity production is a central function of banks. High leverage is optimal for banks in a model that has just enough frictions for banks to have a meaningful role in liquid-claim production. The model has a market premium for (socially valuable) safe/liquid debt, but no taxes or other traditional motives to lever up. Because only safe debt commands a liquidity premium, banks in the model use risk management to maximize their capacity to include such debt in the capital structure. The model can explain (i) why banks have higher leverage than most operating firms, (ii) why risk management is central to banks’ operating policies, (iii) why bank leverage increased over the last 150 years or so, and (iv) why leverage limits for regulated banks impede their ability to compete with unregulated shadow banks.
Number of Pages in PDF File: 40
Keywords: bank capital requirements, leverage, liquidity
JEL Classification: G21, G32, E42, E51, G01, L51working papers series
Date posted: April 23, 2013 ; Last revised: February 27, 2014
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