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Financing as a supply chain: The capital structure of banks and borrowers

Will Gornall and Ilya A. Strebulaev

Journal of Financial Economics, 2018, vol. 129, issue 3, 510-530

Abstract: We develop a model of the joint capital structure decisions of banks and their borrowers. Bank leverage of 85% or higher emerges because bank seniority both dramatically reduces bank asset volatility and incentivizes risk-taking by producing a skewed return distribution. Nonfinancial firms choose low leverage to protect their banks, presenting a partial resolution to the low-leverage puzzle. Our setup naturally extends to include government actions as we model bank assets using a modified Basel framework. Deposit insurance and bailout expectations lead banks and borrowers to take on more risk. Capital regulation lowers bank leverage but can increase bank risk due to a compensating increase in borrower leverage. Despite this, doubling current capital requirements reduces bank default risk by up to 90%, with only a small increase in loan interest rates.

Keywords: Banking; Capital structure; Capital regulation; Seniority; Diversification (search for similar items in EconPapers)
JEL-codes: G2 G18 G21 G28 G32 G38 (search for similar items in EconPapers)
Date: 2018
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Handle: RePEc:eee:jfinec:v:129:y:2018:i:3:p:510-530