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)
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 role of banks. High leverage is optimal for banks in a capital structure model in which there is a market premium for (socially valuable) liquid financial claims and no deviations from Modigliani and Miller (1958) due to agency problems, deposit insurance, taxes, or other distortions. This model can explain (i) why bank leverage increased over the last 150 years or so, (ii) why high bank leverage per se does not necessarily cause systemic risk, and (iii) why leverage limits for regulated banks impede their ability to compete with unregulated shadow banks. Although MM’s debt-equity neutrality principle does not hold in our model, the model’s implications are fully consistent with the MM principle that operating policy is the dominant source of firm value: Creation of a capital structure with abundant (safe) debt is the optimal operating policy of financial intermediaries that specialize in the production of liquid financial claims in our model.
Number of Pages in PDF File: 26
Keywords: bank capital requirements, leverage, liquidity
JEL Classification: G21, G32, E42, E51, G01, L51working papers series
Date posted: April 23, 2013 ; Last revised: September 12, 2013
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