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

Author

Listed:
  • Tanaka, Misa

    () (Bank of England)

  • Vourdas, John

    () (European Central Bank)

Abstract

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.

Suggested Citation

  • Tanaka, Misa & Vourdas, John, 2018. "Equity, debt and moral hazard: the optimal structure of banks’ loss absorbing capacity," Bank of England working papers 745, Bank of England.
  • Handle: RePEc:boe:boeewp:0745
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    File URL: https://www.bankofengland.co.uk/-/media/boe/files/working-paper/2018/equity-debt-and-moral-hazard-the-optimal-structure-of-banks-loss-absorbing-capacity.pdf
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    References listed on IDEAS

    as
    1. Mailath George J. & Mester Loretta J., 1994. "A Positive Analysis of Bank Closure," Journal of Financial Intermediation, Elsevier, vol. 3(3), pages 272-299, June.
    2. 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.
    3. Martynova, Natalya & Perotti, Enrico, 2018. "Convertible bonds and bank risk-taking," Journal of Financial Intermediation, Elsevier, vol. 35(PB), pages 61-80.
    4. 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.
    5. 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.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Bank capital; bank capital regulation; total loss absorbing capacity; bank resolution;

    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
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation

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