Making Bank: Why High Bank Leverage is Optimal – For the Bank's Shareholders

40 Pages Posted: 20 Aug 2015 Last revised: 28 Jul 2016

See all articles by Nikhil Atreya

Nikhil Atreya

Norwegian Center for Taxation at NHH Norwegian School of Economics

Aksel Mjøs

Norwegian School of Economics (NHH) - Department of Finance

Svein-Arne Persson

Norwegian School of Economics (NHH)

Date Written: February 1, 2016

Abstract

High bank leverage is commonly considered a major threat to financial stability. We build a structural credit model to calculate the optimal leverage for a bank that provides asset backed loans, such as corporate loans and mortgages. The bank’s assets are loans, which means that the bank’s exposure to risk is mitigated by the borrower’s equity. We capture the effect of this mitigation by including the borrower’s leverage, in addition to its asset volatility, as the sources of risk for the bank. Our results contribute a quantitative explanation for the high levels of observed bank leverage. When unconstrained by regulation, the bank’s shareholders find it optimal, for reasonable values of borrower risk parameters, to select a bank leverage close to 100%.

Suggested Citation

Atreya, Nikhil and Mjøs, Aksel and Persson, Svein-Arne, Making Bank: Why High Bank Leverage is Optimal – For the Bank's Shareholders (February 1, 2016). 28th Australasian Finance and Banking Conference. Available at SSRN: https://ssrn.com/abstract=2647274 or http://dx.doi.org/10.2139/ssrn.2647274

Nikhil Atreya

Norwegian Center for Taxation at NHH Norwegian School of Economics ( email )

Helleveien 30
Bergen, NO-5045
Norway

Aksel Mjøs

Norwegian School of Economics (NHH) - Department of Finance ( email )

Helleveien 30
N-5045 Bergen
Norway

Svein-Arne Persson (Contact Author)

Norwegian School of Economics (NHH) ( email )

Helleveien 30
Bergen, NO-5045
Norway
47-55-95-90-00 (Phone)
47-55-95-96-47 (Fax)

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