The Optimal Capital Structure of an Economy

33 Pages Posted: 1 Oct 2003

See all articles by Hans Gersbach

Hans Gersbach

ETH Zurich - CER-ETH -Center of Economic Reseaarch; IZA Institute of Labor Economics; CESifo (Center for Economic Studies and Ifo Institute); Centre for Economic Policy Research (CEPR)

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Date Written: August 2003

Abstract

We examine the optimal allocation of equity and debt across banks and industrial firms when both are faced with incentive problems and firms borrow from banks. Increasing bank equity mitigates the bank-level moral hazard but may exacerbate the firm-level moral hazard due to the dilution of firm equity. Competition among banks does not result in a socially efficient level of equity. Imposing capital requirements on banks leads to the socially optimal capital structure of the economy in the sense of maximizing aggregate output. Such capital regulation is second-best and must balance three costs: excessive risk-taking of banks, credit restrictions banks impose on firms with low equity, and credit restrictions due to high loan interest rates.

Keywords: Financial intermediation, double incentive problems, bank capital, banking regulation, capital structure of the economy

JEL Classification: D41, E40, G20

Suggested Citation

Gersbach, Hans, The Optimal Capital Structure of an Economy (August 2003). CEPR Discussion Paper No. 4016. Available at SSRN: https://ssrn.com/abstract=452641

Hans Gersbach (Contact Author)

ETH Zurich - CER-ETH -Center of Economic Reseaarch ( email )

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Zurich, 8092
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IZA Institute of Labor Economics

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Germany

CESifo (Center for Economic Studies and Ifo Institute)

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Germany

Centre for Economic Policy Research (CEPR)

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United Kingdom

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