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

Anjan Thakor (), Viral Acharya and Hamid Mehran

No 8822, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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.

Keywords: Market discipline; Asset substitution; Systemic risk; Bailout (search for similar items in EconPapers)
JEL-codes: G21 G28 G32 G35 G38 (search for similar items in EconPapers)
Date: 2012-02
New Economics Papers: this item is included in nep-ban, nep-cba, nep-cta and nep-reg
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Citations: View citations in EconPapers (9)

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Related works:
Journal Article: Caught between Scylla and Charybdis? Regulating Bank Leverage When There Is Rent Seeking and Risk Shifting (2016)
Working Paper: Caught between Scylla and Charybdis? Regulating bank leverage when there is rent seeking and risk shifting (2010)
Working Paper: Caught between Scylla and Charybdis? Regulating bank leverage when there is rent seeking and risk shifting (2010)
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