Bank capital and the optimal capital structure of an economy
AbstractIn this paper, we provide an economy-wide perspective on equity and debt across banks and industrial firms when both are faced with incentive problems and equity is scarce. Increasing bank equity may mitigate the bank-level moral hazard but exacerbates the firm-level moral hazard due to the reduction of firm equity. Competition among banks tends to result in an inefficiently low level of equity. In this case, imposing capital requirements on banks leads to a socially optimal capital structure for the economy in the sense of maximizing aggregate output. Such capital regulation is second-best and must balance three costs: excessive risk-taking by banks, credit restrictions that banks impose on firms with low equity, and credit restrictions due to high loan-interest rates. We discuss the implications of these findings for capital requirements, competition policy and banking crises.
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Bibliographic InfoArticle provided by Elsevier in its journal European Economic Review.
Volume (Year): 64 (2013)
Issue (Month): C ()
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Web page: http://www.elsevier.com/locate/eer
Financial intermediation; Double incentive problems; Bank capital; Banking regulation; Capital structure of the economy;
Find related papers by JEL classification:
- D41 - Microeconomics - - Market Structure and Pricing - - - Perfect Competition
- E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
- G2 - Financial Economics - - Financial Institutions and Services
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