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Caught between Scylla and Charybdis? Regulating bank leverage when there is rent seeking and risk shifting

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

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.

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Paper provided by Federal Reserve Bank of Cleveland in its series Working Paper with number 1024.

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Date of creation: 2010
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Handle: RePEc:fip:fedcwp:1024
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  1. Bhattacharya Sudipto & Thakor Anjan V., 1993. "Contemporary Banking Theory," Journal of Financial Intermediation, Elsevier, vol. 3(1), pages 2-50, October.
  2. Hamid Mehran & Anjan Thakor, 2009. "Bank capital and value in the cross section," Staff Reports 390, Federal Reserve Bank of New York.
  3. Jean Tirole & Emmanuel Farhi, 2010. "Collective Moral Hazard, Maturity Mismatch, and Systemic Bailouts," 2010 Meeting Papers 822, Society for Economic Dynamics.
  4. Alex Edmans & Qi Liu, 2011. "Inside Debt," Review of Finance, European Finance Association, vol. 15(1), pages 75-102.
  5. Viral V. Acharya & Lasse H. Pedersen & Thomas Philippon & Matthew Richardson, 2010. "Measuring systemic risk," Working Paper 1002, Federal Reserve Bank of Cleveland.
  6. George Pennacchi, 2010. "A structural model of contingent bank capital," Working Paper 1004, Federal Reserve Bank of Cleveland.
  7. Viral Acharya & Tanju Yorulmazer, 2007. "Too many to fail - an analysis of time-inconsistency in bank closure policies," Bank of England working papers 319, Bank of England.
  8. Viral V. Acharya & S. Viswanathan, 2010. "Leverage, Moral Hazard and Liquidity," NBER Working Papers 15837, National Bureau of Economic Research, Inc.
  9. Bruno Biais & Catherine Casamatta, 1999. "Optimal Leverage and Aggregate Investment," Journal of Finance, American Finance Association, vol. 54(4), pages 1291-1323, 08.
  10. 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.
  11. Joseph G. Haubrich & Andrew W. Lo, 2013. "Quantifying Systemic Risk," NBER Books, National Bureau of Economic Research, Inc, number haub10-1, December.
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