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Bank capital and the optimal capital structure of an economy

  • Gersbach, Hans

In this paper, we provide an economy-wide perspective on equity and debt across banks and industrial firms when both are faced with incentive problems and equity is scarce. Increasing bank equity may mitigate the bank-level moral hazard but exacerbates the firm-level moral hazard due to the reduction of firm equity. Competition among banks tends to result in an inefficiently low level of equity. In this case, imposing capital requirements on banks leads to a socially optimal capital structure for the economy in the sense of maximizing aggregate output. Such capital regulation is second-best and must balance three costs: excessive risk-taking by banks, credit restrictions that banks impose on firms with low equity, and credit restrictions due to high loan-interest rates. We discuss the implications of these findings for capital requirements, competition policy and banking crises.

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Article provided by Elsevier in its journal European Economic Review.

Volume (Year): 64 (2013)
Issue (Month): C ()
Pages: 241-255

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Handle: RePEc:eee:eecrev:v:64:y:2013:i:c:p:241-255
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  1. Kevin C. Murdock & Thomas F. Hellmann & Joseph E. Stiglitz, 2000. "Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough?," American Economic Review, American Economic Association, vol. 90(1), pages 147-165, March.
  2. Rafael Repullo, 2002. "Capital requirements, market power, and risk-taking in banking," Proceedings 809, Federal Reserve Bank of Chicago.
  3. Holmstrom, Bengt & Tirole, Jean, 1997. "Financial Intermediation, Loanable Funds, and the Real Sector," The Quarterly Journal of Economics, MIT Press, vol. 112(3), pages 663-91, August.
  4. Mathias Dewatripont & Jean Tirole, 1994. "The prudential regulation of banks," ULB Institutional Repository 2013/9539, ULB -- Universite Libre de Bruxelles.
  5. 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.
  6. 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.
  7. Borio Claudio, 2011. "Implementing a Macroprudential Framework: Blending Boldness and Realism," Capitalism and Society, De Gruyter, vol. 6(1), pages 1-25, August.
  8. Gersbach, Hans & Wenzelburger, Jan, 2008. "Do Risk Premia Protect Against Banking Crises?," Macroeconomic Dynamics, Cambridge University Press, vol. 12(S1), pages 100-111, April.
  9. Charles W. Calomiris & Berry Wilson, 1996. "Bank capital and portfolio management: the 1930s capital crunch and scramble to shed risk," Proceedings 521, Federal Reserve Bank of Chicago.
  10. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  11. Xavier Freixas & Jean-Charles Rochet, 1997. "Microeconomics of Banking," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061937, June.
  12. Petersen, Mitchell A & Rajan, Raghuram G, 1995. "The Effect of Credit Market Competition on Lending Relationships," The Quarterly Journal of Economics, MIT Press, vol. 110(2), pages 407-43, May.
  13. Alan D. Morrison & Lucy White, 2005. "Crises and Capital Requirements in Banking," American Economic Review, American Economic Association, vol. 95(5), pages 1548-1572, December.
  14. Bhattacharya, S. & Boot, A.W.A. & Thakor, A.V., 1995. "The Economics of Bank Regulation," Papers 9516, Centro de Estudios Monetarios Y Financieros-.
  15. Martin Hellwig, 2008. "Systemic Risk in the Financial Sector: An Analysis of the Subprime-Mortgage Financial Crisis," Working Paper Series of the Max Planck Institute for Research on Collective Goods 2008_43, Max Planck Institute for Research on Collective Goods.
  16. Gersbach, Hans, 2003. "The Optimal Capital Structure of an Economy," CEPR Discussion Papers 4016, C.E.P.R. Discussion Papers.
  17. Drew Fudenberg & Jean Tirole, 1991. "Game Theory," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061414, June.
  18. Blum, Jurg & Hellwig, Martin, 1995. "The macroeconomic implications of capital adequacy requirements for banks," European Economic Review, Elsevier, vol. 39(3-4), pages 739-749, April.
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