Caught between Scylla and Charybdis? Regulating Bank Leverage When There is Rent Seeking and Risk Shifting

54 Pages Posted: 15 Mar 2011 Last revised: 9 Oct 2015

See all articles by Viral V. Acharya

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

Hamid Mehran

Independent

Anjan V. Thakor

Washington University, Saint Louis - John M. Olin School of Business; European Corporate Governance Institute (ECGI)

Multiple version iconThere are 3 versions of this paper

Date Written: September 11, 2015

Abstract

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.

Keywords: market discipline, asset substitution, systemic risk, bailout, forbearance, moral hazard, capital requirements

JEL Classification: G21, G28, G32, G35, G38

Suggested Citation

Acharya, Viral V. and Mehran, Hamid and Thakor, Anjan V., Caught between Scylla and Charybdis? Regulating Bank Leverage When There is Rent Seeking and Risk Shifting (September 11, 2015). AFA 2012 Chicago Meetings Paper; European Corporate Governance Institute (ECGI) - Finance Working Paper No. 365/2013. Available at SSRN: https://ssrn.com/abstract=1786637 or http://dx.doi.org/10.2139/ssrn.1786637

Viral V. Acharya

New York University - Leonard N. Stern School of Business ( email )

44 West 4th Street
Suite 9-160
New York, NY NY 10012
United States

HOME PAGE: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/~vacharya.htm

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Hamid Mehran

Independent ( email )

No Address Available

Anjan V. Thakor (Contact Author)

Washington University, Saint Louis - John M. Olin School of Business ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

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