The Optimal Capital Structure of an Economy

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.