Bank Leverage, Welfare, and Regulation

22 Pages Posted: 2 Oct 2018 Last revised: 10 May 2019

See all articles by Anat R. Admati

Anat R. Admati

Stanford Graduate School of Business

Martin F. Hellwig

Max Planck Institute for Research on Collective Goods; University of Bonn - Department of Economics

Date Written: April 30, 2019

Abstract

We take issue with claims that the funding mix of banks, which makes them fragile and crisis-prone, is efficient because it reflects special liquidity benefits of bank debt. Even aside from neglecting the systemic damage to the economy that banks’ distress and default cause, such claims are invalid because banks have multiple small creditors and are unable to commit effectively to their overall funding mix and investment strategy ex ante. The resulting market outcomes under laissez-faire are inefficient and involve excessive borrowing, with default risks that jeopardize the purported liquidity benefits. Contrary to claims in the literature that “equity is expensive” and that regulation requiring more equity in the funding mix entails costs to society, such regulation actually helps create useful commitment for banks to avoid the inefficiently high borrowing that comes under laissez-faire. Effective regulation is beneficial even without considering systemic risk; if such regulation also reduces systemic risk, the benefits are even larger. September 27, 2018, revised January 23, 2019

Keywords: Liquidity in banking, leverage in banking, banking regulation, capital structure, capital regulations, agency costs, commitment, contracting, maturity rat race, leverage ratchet effect, Basel

JEL Classification: D004, D53, D61, G01, G18, G21, G24, G28, G32, G38, H81, K23

Suggested Citation

Admati, Anat R. and Hellwig, Martin F., Bank Leverage, Welfare, and Regulation (April 30, 2019). Rock Center for Corporate Governance at Stanford University Working Paper No. 235; Stanford University Graduate School of Business Research Paper No. 3729; MPI Collective Goods Discussion Paper, No. 2018/13. Available at SSRN: https://ssrn.com/abstract=3257957 or http://dx.doi.org/10.2139/ssrn.3257957

Anat R. Admati (Contact Author)

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States
650-723-4987 (Phone)
650-725-6152 (Fax)

Martin F. Hellwig

Max Planck Institute for Research on Collective Goods ( email )

Kurt-Schumacher-Str. 10
D-53113 Bonn, 53113
Germany

University of Bonn - Department of Economics

Adenauerallee 24-42
D-53113 Bonn
Germany

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