The Optimal Capital Structure of an Economy

Abstract

In a general equilibrium model we examine the optimal allocation of equity and debt across banks and industrial firms when both are plagued by incentive problems and firms can borrow from banks. Competition among banks will not result in a socially efficient level of equity. Imposing capital requirements on banks can trigger the socially optimal capital structure of an economy in the sense of maximizing aggregate output. Such capital regulation is second-best and must balance three costs: gambling of banks, credit restrictions banks impose on firms with low equity, and credit restrictions because of high loan interest rates.

Keywords: Financial intermediation, double incentive problems, bank capital, banking regulation, capital structure of the economy

JEL Classification: D41, E4, G2