Equity, debt and moral hazard: the optimal structure of banks’ loss absorbing capacity

This paper develops a model to analyse the optimal ex-ante capital and total loss absorbing capacity (TLAC) requirements, and the ex-post resolution policy of banks. Banks in our model are subject to two types of moral hazard: i) ex-ante, they have the incentive to shirk on project monitoring, thus increasing the risk of failure, and ii) ex-post, poorly capitalised banks have the incentive to engage in asset substitution by ‘gambling for resurrection’. Ex-ante moral hazard can be eliminated by ensuring that banks have sufficient capital and uninsured ‘bail-inable’ debt, while ex-post moral hazard is mitigated by triggering resolution when the minimum capital requirement is breached. We argue that optimal regulation consists of a high TLAC requirement and high capital buffer. Our analysis also suggests that higher system-wide risk would call for a higher capital buffer, but TLAC could be lowered if it does not jeopardise the credibility of bail-in itself.