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

Author(s): Viral V. Acharya, Hamid Mehran, Anjan Thakor

CEPR Discussion Paper Number 8822
Paper Details | PDF Download* | Purchase Electronic | Purchase Printed

Programme Area(s): Financial Economics (FE)

Date of Publication: 01/02/2012

Keyword(s): asset substitution, bailout, market discipline, systemic risk

JEL(s): G21, G28, G32, G35, G38

Abstract: We consider a model in which banks face two moral hazard problems: 1) asset substitution by shareholders, which can occur when banks make socially-inefficient, risky loans; and 2) managerial under-provision of effort in loan monitoring. The privately-optimal level of bank leverage is neither too low nor too high: It efficiently balances the market discipline that owners of risky debt impose on managerial shirking in monitoring loans 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 action generates an equilibrium featuring systemic risk, in which all banks choose inefficiently high leverage to fund correlated, excessively risky assets. That is, regulatory forbearance itself becomes a source of systemic risk. Leverage can be reduced via a minimum equity capital requirement, which can rule out asset substitution. But this also compromises market discipline by making bank debt too safe. Optimal capital regulation requires that a part of bank capital be invested in safe assets and be attached with contingent distribution rights, in particular, be unavailable to creditors upon failure so as to retain market discipline and be made available to shareholders only contingent on good performance in order to contain risk-taking.

* CEPR Research Fellows and Affiliates, Corporate Members and Subscribers can download papers without charge. Individual Papers may be purchased at www.cepr.org