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The Optimal Capital Structure of Banks: Balancing Deposit Insurance, Capital Requirements and Tax-Advantaged Debt

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Author Info

  • John P. Harding

    (University of Connecticut)

  • Xiaozhing Liang

    (State Street Corporation)

  • Stephen L. Ross

    (University of Connecticut)

Abstract

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 bank's 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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Bibliographic Info

Paper provided by University of Connecticut, Department of Economics in its series Working papers with number 2007-29.

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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.
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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/
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References

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  1. David A. Marshall & Edward S. Prescott, 2000. "Bank capital regulation with and without state-contingent penalties," Working Paper Series WP-00-10, Federal Reserve Bank of Chicago.
  2. Myers, Stewart C, 1984. " The Capital Structure Puzzle," Journal of Finance, American Finance Association, vol. 39(3), pages 575-92, July.
  3. Eugene F. Fama & Kenneth R. French, . "Testing Tradeoff and Pecking Order Predictions about Dividends and Debt.”," CRSP working papers 506, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  4. Leland, Hayne E, 1994. " Corporate Debt Value, Bond Covenants, and Optimal Capital Structure," Journal of Finance, American Finance Association, vol. 49(4), pages 1213-52, September.
  5. Myers, Stewart C., 1984. "Capital structure puzzle," Working papers 1548-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  6. Gueyie, Jean-Pierre & Lai, Van Son, 2003. "Bank moral hazard and the introduction of official deposit insurance in Canada," International Review of Economics & Finance, Elsevier, vol. 12(2), pages 247-273.
  7. Myers, Stewart C. & Majluf, Nicolás S., 1945-, 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Working papers 1523-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  8. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
  9. Keeley, Michael C, 1990. "Deposit Insurance, Risk, and Market Power in Banking," American Economic Review, American Economic Association, vol. 80(5), pages 1183-1200, December.
  10. 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.
  11. Jensen, Michael C, 1986. "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review, American Economic Association, vol. 76(2), pages 323-29, May.
  12. Leland, Hayne E & Toft, Klaus Bjerre, 1996. " Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Journal of Finance, American Finance Association, vol. 51(3), pages 987-1019, July.
  13. Stewart C. Myers & Nicholas S. Majluf, 1984. "Corporate Financing and Investment Decisions When Firms Have InformationThat Investors Do Not Have," NBER Working Papers 1396, National Bureau of Economic Research, Inc.
  14. Douglas W. Diamond, 2001. "Should banks be capitalized?," Economic Quarterly, Federal Reserve Bank of Richmond, issue Fall, pages 71-96.
  15. Merton, Robert C., 1977. "On the cost of deposit insurance when there are surveillance costs," Working papers 903-77., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  16. Myers, Stewart C. & Majluf, Nicholas S., 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Journal of Financial Economics, Elsevier, vol. 13(2), pages 187-221, June.
  17. Buser, Stephen A & Chen, Andrew H & Kane, Edward J, 1981. "Federal Deposit Insurance, Regulatory Policy, and Optimal Bank Capital," Journal of Finance, American Finance Association, vol. 36(1), pages 51-60, March.
  18. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "An Intertemporal General Equilibrium Model of Asset Prices," Econometrica, Econometric Society, vol. 53(2), pages 363-84, March.
  19. Stewart C. Myers, 1984. "Capital Structure Puzzle," NBER Working Papers 1393, National Bureau of Economic Research, Inc.
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Citations

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Cited by:
  1. Casey Mulligan & Luke Threinen, 2008. "Market Responses to the Panic of 2008," NBER Working Papers 14446, National Bureau of Economic Research, Inc.
  2. Nordal, Kjell Bjørn, 2009. "A real options approach for evaluating the implementation of a risk-sensitive capital rule in banks," Review of Financial Economics, Elsevier, vol. 18(3), pages 132-141, August.
  3. Stig Helberg & Snorre Lindset, 2013. "Bank Debt Regulations Implications for Bank Capital and Bond Risk," Working Paper Series 14813, Department of Economics, Norwegian University of Science and Technology.

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