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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 Thakor

This paper examines how much capital banks should optimally hold. Our model encompasses different kinds of moral hazard studied in banking: asset substitution (or risk shifting, e.g., making risky, negative net present value loans), managerial rent seeking (e.g., shirking or investing in inefficient “pet” projects that yield private benefits), and the free cash flow problem (manifesting as inefficient consumption of cash for perquisites by the manager). The privately optimal capital structure of the bank balances the benefit of leverage as reflected in the market discipline imposed by uninsured creditors on rent seeking on the one hand and the cost of leverage as reflected in the asset substitution induced at high levels of leverage on the other hand. Under some conditions, the capital structure resolves all the moral hazard problems we study, but under other conditions, the goal of having the market discipline of leverage clashes with the goal of having the benefit of equity capital in attenuating asset substitution moral hazard. In this case, private contracting must tolerate some form of inefficiency and bank value is not maximized as it is in the first best. Despite this, there is no economic rationale for regulation. However, when bank failures are correlated and en masse failures can impose significant social costs, regulators may intervene ex post via bank bailouts. Anticipation of this generates multiple Nash equilibria, one of which features systemic risk in that all banks choose inefficiently high leverage, take excessively correlated asset risk, and, because debt is paid off by regulators when banks fail en masse, market discipline is compromised. While a simple minimum (tier-1) capital requirement suffices to restore efficiency under some conditions, there are also conditions under which an optimal arrangement to contain the build-up of systemic risk takes the form of the regular (tier-1) capital requirement plus a “special capital account” that involves 1) building up capital via dividend payout restrictions, 2) investment of the retained earnings in designated assets, and 3) contingent distribution provisions.

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Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 469.

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Date of creation: 2010
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Handle: RePEc:fip:fednsr:469
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  1. Emmanuel Farhi & Jean Tirole, 2009. "Collective Moral Hazard, Maturity Mismatch and Systemic Bailouts," NBER Working Papers 15138, National Bureau of Economic Research, Inc.
  2. Acharya, Viral V. & Yorulmazer, Tanju, 2007. "Too many to fail--An analysis of time-inconsistency in bank closure policies," Journal of Financial Intermediation, Elsevier, vol. 16(1), pages 1-31, January.
  3. Alex Edmans & Qi Liu, 2011. "Inside Debt," Review of Finance, European Finance Association, vol. 15(1), pages 75-102.
  4. Hamid Mehran, 0. "Bank Capital and Value in the Cross-Section," Review of Financial Studies, Society for Financial Studies, vol. 24(4), pages 1019-1067.
  5. Viral V. Acharya & S. Viswanathan, 2011. "Leverage, Moral Hazard, and Liquidity," Journal of Finance, American Finance Association, vol. 66(1), pages 99-138, 02.
  6. George Pennacchi, 2010. "A structural model of contingent bank capital," Working Paper 1004, Federal Reserve Bank of Cleveland.
  7. Bruno Biais & Catherine Casamatta, 1999. "Optimal Leverage and Aggregate Investment," Journal of Finance, American Finance Association, vol. 54(4), pages 1291-1323, 08.
  8. Bhattacharya Sudipto & Thakor Anjan V., 1993. "Contemporary Banking Theory," Journal of Financial Intermediation, Elsevier, vol. 3(1), pages 2-50, October.
  9. 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.
  10. Viral V. Acharya & Lasse H. Pedersen & Thomas Philippon & Matthew Richardson, 2010. "Measuring systemic risk," Working Paper 1002, Federal Reserve Bank of Cleveland.
  11. Joseph G. Haubrich & Andrew W. Lo, 2013. "Quantifying Systemic Risk," NBER Books, National Bureau of Economic Research, Inc, number haub10-1, October.
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