Liquid-Claim Production, Risk Management, and Bank Capital Structure: Why High Leverage is Optimal for Banks

45 Pages Posted: 23 Apr 2013 Last revised: 18 Oct 2014

Harry DeAngelo

University of Southern California - Marshall School of Business - Finance and Business Economics Department

René M. Stulz

Ohio State University (OSU) - Department of Finance; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Multiple version iconThere are 2 versions of this paper

Date Written: October 17, 2014

Abstract

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 with risky assets use risk management to maximize their capacity to include such debt in the capital structure. The model can explain why banks have higher leverage than most operating firms, why risk management is central to banks’ operating policies, why bank leverage increased over the last 150 years or so, and why leverage limits for regulated banks impede their ability to compete with unregulated shadow banks.

Keywords: Capital structure, banks, capital regulation

JEL Classification: G21, G32

Suggested Citation

DeAngelo, Harry and Stulz, René M., Liquid-Claim Production, Risk Management, and Bank Capital Structure: Why High Leverage is Optimal for Banks (October 17, 2014). Charles A. Dice Center Working Paper No. 2013-8; Fisher College of Business Working Paper No. 2013-03-08; ECGI - Finance Working Paper No. 356. Available at SSRN: https://ssrn.com/abstract=2254998 or http://dx.doi.org/10.2139/ssrn.2254998

Harry DeAngelo

University of Southern California - Marshall School of Business - Finance and Business Economics Department ( email )

Marshall School of Business
Los Angeles, CA 90089
United States
213-740-6541 (Phone)
213-740-6650 (Fax)

Rene M. Stulz (Contact Author)

Ohio State University (OSU) - Department of Finance ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States

HOME PAGE: http://www.cob.ohio-state.edu/fin/faculty/stulz

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

European Corporate Governance Institute (ECGI)

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

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