The capital structure and regulation of financial intermediaries is an important topic for practitioners, regulators and academic researchers. In general, theory predicts that firms choose their capital structures by balancing the benefits of debt (e.g., tax and agency benefits) against its costs (e.g., bankruptcy costs). However, when traditional corporate finance models have been applied to insured financial institutions, the results have generally predicted corner solutions (all equity or all debt) to the capital structure problem. This paper studies the impact and interaction of deposit insurance, capital requirements and tax benefits on a bankÇs choice of optimal capital structure. Using a contingent claims model to value the firm and its associated claims, we find that there exists an interior optimal capital ratio in the presence of deposit insurance, taxes and a minimum fixed capital standard. Banks voluntarily choose to maintain capital in excess of the minimum required in order to balance the risks of insolvency (especially the loss of future tax benefits) against the benefits of additional debt. Because we derive a closed- form solution, our model provides useful insights on several current policy debates including revisions to the regulatory framework for GSEs, tax policy in general and the tax exemption for credit unions.
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Paper provided by University of Connecticut, Department of Economics in its series Working papers with number
2007-29.
Length: 51 pages Date of creation: Jul 2007 Date of revision:
Feb 2008 Handle: RePEc:uct:uconnp:2007-29
Note: We wish to thank Dwight Jaffee, William Lang, Wenli Li, Nancy Wallace and James Wilcox for comments, as well as participants at seminars given at the Haas School, the Federal Reserve Banks of Philadelphia and St. Louis, FannieMae, and State Street Corporation. Contact details of provider: Postal: University of Connecticut 341 Mansfield Road, Unit 1063 Storrs, CT 06269-1063 Phone: (860) 486-4889 Fax: (860) 486-4463 Web page: http://www.econ.uconn.edu/ More information through EDIRC
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Douglas W. Diamond & Raghuram G. Rajan, 2000.
"A Theory of Bank Capital,"
Journal of Finance,
American Finance Association, vol. 55(6), pages 2431-2465, December.
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Other versions:
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.
Myers, Stewart C. & Sloan School of Management., 1984.
"Capital structure puzzle,"
Working papers
1548-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
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