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The Optimal Capital Structure of an Economy

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  • Gersbach, Hans

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.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4016.

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Date of creation: Aug 2003
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Handle: RePEc:cpr:ceprdp:4016

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Related research

Keywords: bank capital; banking regulation; capital structure of the economy; double incentive problems; financial intermediation;

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  1. Douglas W. Diamond & Raghuram G. Rajan, . "A Theory of Bank Capital," CRSP working papers 363, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  2. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  3. Calomiris, Charles W & Kahn, Charles M, 1991. "The Role of Demandable Debt in Structuring Optimal Banking Arrangements," American Economic Review, American Economic Association, vol. 81(3), pages 497-513, June.
  4. Holmstrom, Bengt & Tirole, Jean, 1997. "Financial Intermediation, Loanable Funds, and the Real Sector," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 112(3), pages 663-91, August.
  5. Takeo Hoshi & Anil Kashyap & David Scharfstein, 1993. "The Choice Between Public and Private Debt: An Analysis of Post-Deregulation Corporate Financing in Japan," NBER Working Papers 4421, National Bureau of Economic Research, Inc.
  6. Bhattacharya, S. & Boot, A.W.A. & Thakor, A.V., 1995. "The Economics of Bank Regulation," Papers, Centro de Estudios Monetarios Y Financieros- 9516, Centro de Estudios Monetarios Y Financieros-.
  7. Besanko, David & Kanatas, George, 1993. "Credit Market Equilibrium with Bank Monitoring and Moral Hazard," Review of Financial Studies, Society for Financial Studies, vol. 6(1), pages 213-32.
  8. Boot, Arnoud W A & Thakor, Anjan, 1995. "Financial System Architecture," CEPR Discussion Papers, C.E.P.R. Discussion Papers 1197, C.E.P.R. Discussion Papers.
  9. Blum, Jurg & Hellwig, Martin, 1995. "The macroeconomic implications of capital adequacy requirements for banks," European Economic Review, Elsevier, vol. 39(3-4), pages 739-749, April.
  10. Xavier Freixas & Jean-Charles Rochet, 1997. "Microeconomics of Banking," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061937, December.
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Cited by:
  1. Hans Gersbach & Volker Hahn, 2011. "Modeling Two Macro Policy Instruments - Interest Rates and Aggregate Capital Requirements," CESifo Working Paper Series 3598, CESifo Group Munich.
  2. Hans Gersbach, 2013. "Preventing Banking Crises--with Private Insurance?," CESifo Economic Studies, CESifo, CESifo, vol. 59(4), pages 609-627, December.
  3. Gersbach, Hans, 2013. "Bank capital and the optimal capital structure of an economy," European Economic Review, Elsevier, vol. 64(C), pages 241-255.

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