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Caught between Scylla and Charybdis? Regulating bank leverage when there is rent-seeking and risk-shifting

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  • Acharya, Viral V
  • Mehran, Hamid
  • Thakor, Anjan

Abstract

We consider a model in which banks face two moral hazard problems: 1) asset substitution by shareholders, which can occur when banks make socially-inefficient, risky loans; and 2) managerial under-provision of effort in loan monitoring. The privately-optimal level of bank leverage is neither too low nor too high: It efficiently balances the market discipline that owners of risky debt impose on managerial shirking in monitoring loans against the asset substitution induced at high levels of leverage. However, when correlated bank failures can impose significant social costs, regulators may bail out bank creditors. Anticipation of this action generates an equilibrium featuring systemic risk, in which all banks choose inefficiently high leverage to fund correlated, excessively risky assets. That is, regulatory forbearance itself becomes a source of systemic risk. Leverage can be reduced via a minimum equity capital requirement, which can rule out asset substitution. But this also compromises market discipline by making bank debt too safe. Optimal capital regulation requires that a part of bank capital be invested in safe assets and be attached with contingent distribution rights, in particular, be unavailable to creditors upon failure so as to retain market discipline and be made available to shareholders only contingent on good performance in order to contain risk-taking.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8822.

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Date of creation: Feb 2012
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Handle: RePEc:cpr:ceprdp:8822

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Keywords: asset substitution; bailout; market discipline; systemic risk;

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  1. Viral Acharya & Tanju Yorulmazer, 2007. "Too many to fail - an analysis of time-inconsistency in bank closure policies," Bank of England working papers 319, Bank of England.
  2. Bruno Biais & Catherine Casamatta, 1999. "Optimal Leverage and Aggregate Investment," Journal of Finance, American Finance Association, vol. 54(4), pages 1291-1323, 08.
  3. Hamid Mehran, 0. "Bank Capital and Value in the Cross-Section," Review of Financial Studies, Society for Financial Studies, vol. 24(4), pages 1019-1067.
  4. Joseph G. Haubrich & Andrew W. Lo, 2013. "Quantifying Systemic Risk," NBER Books, National Bureau of Economic Research, Inc, number haub10-1, July.
  5. Acharya, Viral V & Pedersen, Lasse H & Philippon, Thomas & Richardson, Matthew P, 2012. "Measuring Systemic Risk," CEPR Discussion Papers 8824, C.E.P.R. Discussion Papers.
  6. Emmanuel Farhi & Jean Tirole, 2012. "Collective Moral Hazard, Maturity Mismatch, and Systemic Bailouts," American Economic Review, American Economic Association, vol. 102(1), pages 60-93, February.
  7. 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.
  8. Viral V. Acharya & S. Viswanathan, 2011. "Leverage, Moral Hazard, and Liquidity," Journal of Finance, American Finance Association, vol. 66(1), pages 99-138, 02.
  9. Alex Edmans & Qi Liu, 2011. "Inside Debt," Review of Finance, European Finance Association, vol. 15(1), pages 75-102.
  10. George Pennacchi, 2010. "A structural model of contingent bank capital," Working Paper 1004, Federal Reserve Bank of Cleveland.
  11. Bhattacharya Sudipto & Thakor Anjan V., 1993. "Contemporary Banking Theory," Journal of Financial Intermediation, Elsevier, vol. 3(1), pages 2-50, October.
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