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Caught between Scylla and Charybdis? Regulating Bank Leverage When There Is Rent Seeking and Risk Shifting

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

Abstract

We develop a theory of optimal bank leverage in which the benefit of debt in inducing loan monitoring is balanced against the benefit of equity in attenuating risk shifting. However, faced with socially costly correlated bank failures, regulators bail out creditors. Anticipation of this generates multiple equilibria, including one with systemic risk in which banks use excessive leverage to fund correlated, inefficiently risky loans. Limiting leverage and resolving both moral hazards—insufficient loan monitoring and asset substitution—requires a novel two-tiered capital requirement, including a “special capital account” that is unavailable to creditors upon failure.

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  • Viral V. Acharya & Hamid Mehran & Anjan V. Thakor, 2016. "Caught between Scylla and Charybdis? Regulating Bank Leverage When There Is Rent Seeking and Risk Shifting," The Review of Corporate Finance Studies, Society for Financial Studies, vol. 5(1), pages 36-75.
    • Handle: RePEc:oup:rcorpf:v:5:y:2016:i:1:p:36-75.
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    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G35 - Financial Economics - - Corporate Finance and Governance - - - Payout Policy
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation

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