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Why High Leverage Is Optimal for Banks

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  • DeAngelo, Harry

    (University of Southern CA)

  • Stulz, Rene M.

    (OH State University and ECGI)

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    Abstract

    Liquidity production is a central role of banks. When there is a market premium for the production of (socially valuable) liquid financial claims and no other departures from the Modigliani and Miller (1958, MM) assumptions, we show that high leverage is optimal for banks. In this model, high leverage is not the result of distortions from agency problems, deposit insurance, or tax motives to borrow. The model can explain (i) why bank leverage increased over the last 150 years or so without invoking any of these distortions, (ii) why high bank leverage per se does not necessarily cause systemic risk, and (iii) why limits on the leverage of regulated banks impede their ability to compete with unregulated shadow banks. MM's leverage irrelevance theorem is inapplicable to banks: Because debt-equity neutrality assigns zero weight to the social value of liquidity, it is an inappropriately equity-biased baseline for assessing whether the high leverage ratios of real-world banks are excessive or socially destructive.

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    Bibliographic Info

    Paper provided by Ohio State University, Charles A. Dice Center for Research in Financial Economics in its series Working Paper Series with number 2013-08.

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    Date of creation: May 2013
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    Handle: RePEc:ecl:ohidic:2013-08

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    Cited by:
    1. Samuel G. Hanson & Andrei Shleifer & Jeremy C. Stein & Robert W. Vishny, 1969. "Banks as Patient Fixed Income Investors," Working Paper 151246, Harvard University OpenScholar.

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