Bank Capital Structure and Tail Risk
51 Pages Posted: 18 Mar 2020 Last revised: 10 Aug 2021
Date Written: February 23, 2020
This paper presents a bank capital structure model in which bank assets are subject to both diffusion and tail risk. Of these two types of risk, tail risk causes uninsured deposits to be risky, as the bank's asset value can unexpectedly fall below the value of deposits in case of default. The model shows that tail risk, rather than diffusion risk, is the main driver of the risk 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 a high tail risk component leads to higher credit spreads, default risk, and magnitude of bank losses in default than a high diffusion risk component.
Keywords: Banking, Optimal Capital Structure, Financial Regulation, Tail Risk, Jump-Diffusion Models
JEL Classification: G21, G28, G32, G33
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