Equilibrium Theory of Banks' Capital Structure

43 Pages Posted: 23 Aug 2017

See all articles by Douglas M. Gale

Douglas M. Gale

New York University (NYU) - Department of Economics

Piero Gottardi

European University Institute - Department of Economics; Ca Foscari University of Venice - Dipartimento di Economia; CESifo (Center for Economic Studies and Ifo Institute)

Date Written: July 27, 2017

Abstract

We study an environment where the capital structure of banks and firms are jointly determined in equilibrium, so as to balance the benefits of the provision of liquidity services by bank deposits with the costs of bankruptcy. The risk in the assets held by firms and banks is determined by the technology choices by firms and the portfolio diversification choices by banks. We show competitive equilibria are efficient and the equilibrium level of leverage in banks and firms depend on the nature of the shocks affecting firm productivities. When these shocks are co-monotonic, banks optimally choose a zero level of equity. Thus all equity should be in firms, where it does “double duty”. Protecting both firms and banks from default. On the other hand, if productivity shocks have an idiosyncratic component, portfolio diversification by banks may be a more effective buffer against these shocks and, in these cases, it may be optimal for banks, as well as firms, to issue equity.

Keywords: capital structure, banks, bankruptcy

JEL Classification: G330

Suggested Citation

Gale, Douglas M. and Gottardi, Piero, Equilibrium Theory of Banks' Capital Structure (July 27, 2017). CESifo Working Paper Series No. 6580. Available at SSRN: https://ssrn.com/abstract=3023229

Douglas M. Gale

New York University (NYU) - Department of Economics ( email )

269 Mercer Street, 7th Floor
New York, NY 10011
United States
(212) 998-8944 (Phone)
(212) 995-3932 (Fax)

Piero Gottardi (Contact Author)

European University Institute - Department of Economics ( email )

Villa Schifanoia
133 via Bocaccio
Firenze (Florence), Tuscany 50014
Italy

Ca Foscari University of Venice - Dipartimento di Economia ( email )

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Venice, 30121
Italy
+39 041 257 4192 (Phone)
+39 041 257 4176 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

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