Why High Leverage is Optimal for Banks

Harry DeAngelo and René M. Stulz

No 19139, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Liquidity production is a central role of banks. We show that, under idealized conditions, high leverage is optimal for banks when there is a market premium for (socially valuable) liquid financial claims and no deviations from Modigliani and Miller (1958) due to agency problems, deposit insurance, taxes, or any other distortions. Our model can explain (i) why bank leverage increased over the last 150 years or so, (ii) why high bank leverage per se does not necessarily cause systemic risk, and (iii) why limits on the leverage of regulated banks impede their ability to compete with unregulated shadow banks. Our model indicates that MM's debt-equity neutrality principle is inapplicable to banks. Because debt-equity neutrality assigns zero weight to the social value of liquidity, it is an inappropriately equity-biased baseline for assessing whether the high leverage ratios of real-world banks are excessive.

JEL-codes: E42 E51 G01 G21 G32 L51 (search for similar items in EconPapers)
Date: 2013-06
New Economics Papers: this item is included in nep-ban and nep-mac
Note: CF
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Citations: View citations in EconPapers (38)

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Working Paper: Why High Leverage Is Optimal for Banks (2013)
Working Paper: Why High Leverage Is Optimal for Banks (2013)
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