Bank Capital Structure and Tail Risk
47 Pages Posted: 18 Mar 2020
Date Written: February 23, 2020
This paper presents a continuous-time bank capital structure model in which the bank's assets are subject to both diffusion and tail risk. The latter causes uninsured deposits to be risky, as the bank's assets can jump below the threshold at which it is optimal for depositors to run. The model shows that tail risk, rather than diffusion risk, is the main driver of the credit spread on deposits when the bank is unregulated and of the endogenous deposit insurance premium when the bank is regulated. Keeping total volatility constant, the model shows that an increase in tail risk leads to higher credit spreads and bankruptcy costs than an increase of diffusion risk. Furthermore, a bank with frequent but small asset jumps is safer than one with infrequent but large asset jumps.
Keywords: Banking, Optimal Capital Structure, Financial Regulation, Tail Risk, Jump-Diffusion Models
JEL Classification: G21, G28, G32, G33
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