Bank liability structure

Since the fiduciary duty of bank management is to maximize bank value and not social welfare, we analytically solve for the liability structure that maximizes the value of a bank leveraged by deposits and subordinated debt. Our analysis offers a perspective on privately-rational bank capital structure and its interaction with regulatory environment. Absent deposit insurance and regulation, banks use high leverage. The drivers of bank leverage are the low volatility of bank assets and the income from serving deposits, besides corporate taxes. The optimal level of subordinated debt makes its endogenous default coincide with bank run. In response to deposit insurance and regulatory closure, banks increase their value and leverage by expanding deposits, even if they are charged fair insurance premium. They however reduce subordinated debt to keep endogenous default and regulatory closure concurrent. These optimal responses from banks counteract the objective of regulators in lessening expected bankruptcy costs.

“This paper is part of the mini conference on "The Future of Large Financial Institutions" at the 2014 fall meetings of the International Atlantic Economic Society.  Sessions on this and related themes are expected to be continued at the spring 2015 meetings in Milan and the fall 2015 meetings in Boston.”