IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Login to save this paper or follow this series

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.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: http://www.newyorkfed.org/research/staff_reports/sr469.html
Download Restriction: no

File URL: http://www.newyorkfed.org/research/staff_reports/sr469.pdf
Download Restriction: no

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

as
in new window

Length:
Date of creation: 2010
Date of revision:
Handle: RePEc:fip:fednsr:469
Contact details of provider: Postal: 33 Liberty Street, New York, NY 10045-0001
Web page: http://www.newyorkfed.org/
Email:


More information through EDIRC

Order Information: Web: http://www.ny.frb.org/rmaghome/staff_rp/ Email:


References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. Douglas W. Diamond & Raghuram G. Rajan, 1999. "Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking," NBER Working Papers 7430, National Bureau of Economic Research, Inc.
  2. Anat R. Admati & Peter M. DeMarzo & Martin F. Hellwig & Paul Pfleiderer, 2010. "Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive," Working Paper Series of the Max Planck Institute for Research on Collective Goods 2010_42, Max Planck Institute for Research on Collective Goods.
  3. Stulz, ReneM., 1990. "Managerial discretion and optimal financing policies," Journal of Financial Economics, Elsevier, vol. 26(1), pages 3-27, July.
  4. Jean Tirole & Emmanuel Farhi, 2009. "Collective Moral Hazard, Maturity Mismatch and Systemic Bailouts," Working Papers 2009.57, Fondazione Eni Enrico Mattei.
  5. Oliver Hart & John Moore, 1991. "A Theory of Debt Based on the Inalienability of Human Capital," NBER Working Papers 3906, National Bureau of Economic Research, Inc.
  6. Viral V. Acharya & Tanju Yorulmazer, 2008. "Cash-in-the-Market Pricing and Optimal Resolution of Bank Failures," Review of Financial Studies, Society for Financial Studies, vol. 21(6), pages 2705-2742, November.
  7. Bhattacharya Sudipto & Thakor Anjan V., 1993. "Contemporary Banking Theory," Journal of Financial Intermediation, Elsevier, vol. 3(1), pages 2-50, October.
  8. Jensen, Michael C, 1986. "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review, American Economic Association, vol. 76(2), pages 323-29, May.
  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. George Pennacchi, 2010. "A structural model of contingent bank capital," Working Paper 1004, Federal Reserve Bank of Cleveland.
  11. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
  12. Hamid Mehran & Anjan Thakor, 2009. "Bank capital and value in the cross section," Staff Reports 390, Federal Reserve Bank of New York.
  13. Luigi Zingales & Oliver Hart, 2009. "A New Capital Regulation For Large Financial Institutions," Working Papers 2009.124, Fondazione Eni Enrico Mattei.
  14. Acharya, Viral V, 2009. "A Theory of Systemic Risk and Design of Prudential Bank Regulation," CEPR Discussion Papers 7164, C.E.P.R. Discussion Papers.
  15. Edward Kane, 2010. "Redefining and Containing Systemic Risk," Atlantic Economic Journal, International Atlantic Economic Society, vol. 38(3), pages 251-264, September.
  16. Allen, Franklin & Carletti, Elena, 2005. "Credit risk transfer and contagion," CFS Working Paper Series 2005/25, Center for Financial Studies (CFS).
  17. 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.
  18. Calzolari, Giacomo & Lóránth, Gyöngyi, 2004. "Regulation of Multinational banks: A Theoretical Inquiry," CEPR Discussion Papers 4232, C.E.P.R. Discussion Papers.
  19. Mathias Dewatripont & Jean Tirole, 1994. "The prudential regulation of banks," ULB Institutional Repository 2013/9539, ULB -- Universite Libre de Bruxelles.
  20. Alex Edmans & Qi Liu, 2011. "Inside Debt," Review of Finance, European Finance Association, vol. 15(1), pages 75-102.
  21. Acharya, Viral V & Pedersen, Lasse H & Philippon, Thomas & Richardson, Matthew P, 2012. "Measuring Systemic Risk," CEPR Discussion Papers 8824, C.E.P.R. Discussion Papers.
  22. Admati, Anat R. & Pfleiderer, Paul, 2009. "Increased-Liability Equity: A Proposal to Improve Capital Regulation of Large Financial Institutions," Research Papers 2043, Stanford University, Graduate School of Business.
  23. Memmel, Christoph & Raupach, Peter, 2010. "How do banks adjust their capital ratios?," Journal of Financial Intermediation, Elsevier, vol. 19(4), pages 509-528, October.
  24. Shleifer, Andrei & Vishny, Robert W, 1992. " Liquidation Values and Debt Capacity: A Market Equilibrium Approach," Journal of Finance, American Finance Association, vol. 47(4), pages 1343-66, September.
  25. Merton, Robert C., 1977. "An analytic derivation of the cost of deposit insurance and loan guarantees An application of modern option pricing theory," Journal of Banking & Finance, Elsevier, vol. 1(1), pages 3-11, June.
  26. Rochet, Jean-Charles & Villeneuve, Stéphane, 2011. "Liquidity management and corporate demand for hedging and insurance," Journal of Financial Intermediation, Elsevier, vol. 20(3), pages 303-323, July.
  27. Viral V. Acharya & S. Viswanathan, 2010. "Leverage, Moral Hazard and Liquidity," NBER Working Papers 15837, National Bureau of Economic Research, Inc.
  28. Darrell Duffie, 2010. "A Contractual Approach to Restructuring Financial Institutions," Book Chapters, in: Kenneth E. Scott & George P. Shultz & John B. Taylor (ed.), Ending Government Bailouts As We Know Them, chapter 6 Hoover Institution, Stanford University.
  29. Joseph G. Haubrich & Andrew W. Lo, 2013. "Quantifying Systemic Risk," NBER Books, National Bureau of Economic Research, Inc, number haub10-1.
  30. Bengt Holmstrom, 1982. "Moral Hazard in Teams," Bell Journal of Economics, The RAND Corporation, vol. 13(2), pages 324-340, Autumn.
  31. 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.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:fip:fednsr:469. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Amy Farber)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.