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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

Banks face two moral hazard problems: asset substitution by shareholders (e.g., making risky, negative net present value loans) and managerial rent seeking (e.g., investing in inefficient “pet” projects or simply being lazy and uninnovative). The privately-optimal level of bank leverage is neither too low nor too high: It balances effi ciently the market discipline imposed by owners of risky debt on managerial rent-seeking against the asset-substitution induced at high levels of leverage. However, when correlated bank failures can impose significant social costs, regulators may bail out bank creditors. Anticipation of this generates an equilibrium featuring systemic risk in which all banks choose inefficiently high leverage to fund correlated assets. A minimum equity capital requirement can rule out asset substitution but also compromises market discipline by making bank debt too safe. The optimal capital regulation requires that a part of bank capital be unavailable to creditors upon failure, and be available to shareholders only contingent on good performance.

Suggested Citation

  • Viral V. Acharya & Hamid Mehran & Anjan V. Thakor, 2010. "Caught between Scylla and Charybdis? Regulating bank leverage when there is rent seeking and risk shifting," Working Paper 1024, Federal Reserve Bank of Cleveland.
  • Handle: RePEc:fip:fedcwp:1024
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    References listed on IDEAS

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    Cited by:

    1. Mousa Almanaseer, 2014. "The Impact of the Financial Crisis on the Islamic Banks Profitability - Evidence from GCC," International Journal of Financial Research, International Journal of Financial Research, Sciedu Press, vol. 5(3), pages 176-187, July.
    2. Paolo Angelini & Laurent Clerc & Vasco Cúrdia & Leonardo Gambacorta & Andrea Gerali & Alberto Locarno & Roberto Motto & Werner Roeger & Skander Van den Heuvel & Jan Vlček, 2015. "Basel III: Long-term Impact on Economic Performance and Fluctuations," Manchester School, University of Manchester, vol. 83(2), pages 217-251, March.
    3. Allen, Franklin & Carletti, Elena & Marquez, Robert, 2015. "Deposits and bank capital structure," Journal of Financial Economics, Elsevier, vol. 118(3), pages 601-619.
    4. Challe, Edouard & Mojon, Benoit & Ragot, Xavier, 2013. "Equilibrium risk shifting and interest rate in an opaque financial system," European Economic Review, Elsevier, vol. 63(C), pages 117-133.
    5. Viral V. Acharya & Hanh T. Le & Hyun Song Shin, 2017. "Bank Capital and Dividend Externalities," Review of Financial Studies, Society for Financial Studies, vol. 30(3), pages 988-1018.
    6. Hamid Mehran & Alan Morrison & Joel Shapiro, 2011. "Corporate governance and banks: what have we learned from the financial crisis?," Staff Reports 502, Federal Reserve Bank of New York.
    7. Viral V. Acharya & Irvind Gujral & Nirupama Kulkarni & Hyun Song Shin, 2011. "Dividends and Bank Capital in the Financial Crisis of 2007-2009," NBER Working Papers 16896, National Bureau of Economic Research, Inc.
    8. repec:taf:jpolrf:v:20:y:2017:i:4:p:343-359 is not listed on IDEAS
    9. Itai Agur & Maria Demertzis, 2010. "Monetary Policy and Excessive Bank Risk Taking," DNB Working Papers 271, Netherlands Central Bank, Research Department.
    10. Agur, Itai, 2014. "Bank risk within and across equilibria," Journal of Banking & Finance, Elsevier, vol. 48(C), pages 322-333.
    11. Viral V. Acharya & Hamid Mehran & Til Schuermann & Anjan V. Thakor, 2012. "Robust capital regulation," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 18(May).
    12. Emilios Avgouleas, 2015. "Bank Leverage Ratios and Financial Stability: A Micro- and Macroprudential Perspective," Economics Working Paper Archive wp_849, Levy Economics Institute.
    13. Admati, Anat R. & DeMarzo, Peter M. & Hellwig, Martin F. & Pfleiderer, Paul, 2010. "Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity Is Not Expensive," Research Papers 2065, Stanford University, Graduate School of Business.
    14. Manganelli, Simone & Altunbas, Yener & Marqués-Ibáñez, David, 2011. "Bank risk during the financial crisis: do business models matter?," Working Paper Series 1394, European Central Bank.
    15. Agur, Itai & Demertzis, Maria, 2012. "Excessive bank risk taking and monetary policy," Working Paper Series 1457, European Central Bank.
    16. Sokolov, V., 2012. "The Impact of Central Bank Liquidity Infusions on Banks with High Level of Foreign Borrowing during the Crisis," Journal of the New Economic Association, New Economic Association, vol. 13(1), pages 51-78.
    17. Paolo Angelini & Stefano Neri & Fabio Panetta, 2011. "Monetary and macroprudential policies," Temi di discussione (Economic working papers) 801, Bank of Italy, Economic Research and International Relations Area.
    18. Yaron Leitner, 2012. "Contingent capital," Business Review, Federal Reserve Bank of Philadelphia, issue Q2, pages 11-18.
    19. Edmans, Alex, 2011. "Short-term termination without deterring long-term investment: A theory of debt and buyouts," Journal of Financial Economics, Elsevier, vol. 102(1), pages 81-101, October.
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    More about this item

    Keywords

    Bank capital ; Moral hazard ; Systemic risk;

    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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