The Value of the Bank under Endogenous Liquidity Risk: The Modigliani-Miller Theorem Revisited

43 Pages Posted: 18 Oct 2017 Last revised: 22 Oct 2017

See all articles by Linda Schilling

Linda Schilling

Washington University in Saint Louis, John M. Olin Business School

Date Written: October 17, 2017

Abstract

This paper demonstrates that the Modigliani Miller Theorem on capital structure does in general not apply to banks when faced with endogenous liquidity risk in form of bank runs and asset illiquidity. The Modigliani Miller Theorem states that under certain assumptions, firms with different capital structure must have same values if they have identical return distributions (risk class). This paper shows, under endogenous liquidity risk the bank's risk class changes in debt ratio and coupons demanded by depositors such that the Modigliani Miller Theorem can in general not apply when repricing of risk in form of higher coupons is taken into account. In equilibrium, bank value is non-monotone in capital structure. In particular, only the all equity financed bank achieves the highest risk class.

This paper offers a new perspective on Modigliani Miller from the view point of a game theoretic setting in which a bank sets capital structure and coupons to maximize equity value where the bank internalizes the effect her choice has on depositors' coordination behaviour and thus bank stability.

Keywords: Capital Structure, Bank Runs, Global Games, Liquidity Risk, Bankruptcy Costs

JEL Classification: G32, G33, G21, D4

Suggested Citation

Schilling, Linda, The Value of the Bank under Endogenous Liquidity Risk: The Modigliani-Miller Theorem Revisited (October 17, 2017). Becker Friedman Institute for Research in Economics Working Paper No. 3054659, Available at SSRN: https://ssrn.com/abstract=3054659 or http://dx.doi.org/10.2139/ssrn.3054659

Linda Schilling (Contact Author)

Washington University in Saint Louis, John M. Olin Business School ( email )

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