Equity, Debt and Moral Hazard: The Optimal Structure of Banks’ Loss Absorbing Capacity

37 Pages Posted: 14 Aug 2018

See all articles by Misa Tanaka

Misa Tanaka

Bank of England

John Vourdas

European University Institute

Date Written: July 27, 2018

Abstract

This paper develops a model to analyse the optimal ex-ante capital and total loss absorbing capacity (TLAC) requirements, and the ex-post resolution policy of banks. Banks in our model are subject to two types of moral hazard: i) ex-ante, they have the incentive to shirk on project monitoring, thus increasing the risk of failure, and ii) ex-post, poorly capitalised banks have the incentive to engage in asset substitution by ‘gambling for resurrection’. Ex-ante moral hazard can be eliminated by ensuring that banks have sufficient capital and uninsured ‘bail-inable’ debt, while ex-post moral hazard is mitigated by triggering resolution when the minimum capital requirement is breached. We argue that optimal regulation consists of a high TLAC requirement and high capital buffer. Our analysis also suggests that higher system-wide risk would call for a higher capital buffer, but TLAC could be lowered if it does not jeopardise the credibility of bail-in itself.

Keywords: bank capital, bank capital regulation, total loss absorbing capacity, bank resolution

JEL Classification: G21, G28, G33, G38

Suggested Citation

Tanaka, Misa and Vourdas, John, Equity, Debt and Moral Hazard: The Optimal Structure of Banks’ Loss Absorbing Capacity (July 27, 2018). Bank of England Working Paper No. 745, Available at SSRN: https://ssrn.com/abstract=3222716 or http://dx.doi.org/10.2139/ssrn.3222716

Misa Tanaka (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

John Vourdas

European University Institute ( email )

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

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