Bank Regulation and Market Discipline in the Presence of Risk-Shifting Incentives
46 Pages Posted: 26 Jul 2021 Last revised: 10 Aug 2021
Date Written: July 23, 2021
This paper presents a bank capital structure model in which equity holders can increase asset risk once debt is in place. I study the effects of capital requirements and subsidized deposit insurance on the bank's privately optimal funding and operational risk level. The model predicts that there are synergetic effects of regulation and market discipline. When the regulator sets the capital charge and deposit insurance premium payments sufficiently high for a risky portfolio, the bank commits to the low-risk asset portfolio by setting a lower leverage ratio. This market discipline effect disappears when the regulatory costs become too high.
Keywords: Banking, Financial Regulation, Market Discipline, Optimal Capital Structure, Risk-Shifting
JEL Classification: G21, G28, G32, G33
Suggested Citation: Suggested Citation