The Impact of Taxation on Bank Leverage and Asset Risk

Abstract

The tax-benefit of interest deductibility encourages debt financing, but regulatory and market constraints create dependency between bank leverage and risk. Using a large international sample of banks this paper estimates the short and long run effects of corporate income taxes (CIT) on bank capital structure and portfolio risk accounting for their simultaneous determination. A 10 percentage point increase in the statutory CIT rate is associated with an increase of 0.8-1.4 percentage points in bank leverage and a 2-7 percentage point reduction in the average risk-weight of assets. While the estimated overall effect of taxation on bank risk is modest, it induces significant portfolio reallocation toward less lending. These results suggest that any elimination of the tax-bias of debt may not bring the expected benefits for bank stability.

Keywords: Bank leverage; Bank regulation; Bank risk; Corporate taxation; Debt-bias

JEL Classification: G21; G28; G32; H25