The Optimal Capital Structure of Banks: Balancing Deposit Insurance, Capital Requirements and Tax-Advantaged Debt

John P. Harding, Xiaozhong Liang and Stephen Ross
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John P. Harding: University of Connecticut
Xiaozhong Liang: State Street Corporation

No 2007-29, Working papers from University of Connecticut, Department of Economics

Abstract: The capital structure and regulation of financial intermediaries is an important topic for practitioners, regulators and academic researchers. In general, theory predicts that firms choose their capital structures by balancing the benefits of debt (e.g., tax and agency benefits) against its costs (e.g., bankruptcy costs). However, when traditional corporate finance models have been applied to insured financial institutions, the results have generally predicted corner solutions (all equity or all debt) to the capital structure problem. This paper studies the impact and interaction of deposit insurance, capital requirements and tax benefits on a bank's choice of optimal capital structure. Using a contingent claims model to value the firm and its associated claims, we find that there exists an interior optimal capital ratio in the presence of deposit insurance, taxes and a minimum fixed capital standard. Banks voluntarily choose to maintain capital in excess of the minimum required in order to balance the risks of insolvency (especially the loss of future tax benefits) against the benefits of additional debt. Because we derive a closed- form solution, our model provides useful insights on several current policy debates including revisions to the regulatory framework for GSEs, tax policy in general and the tax exemption for credit unions.

Pages: 51 pages
Date: 2007-07, Revised 2008-02
New Economics Papers: this item is included in nep-acc, nep-ban, nep-ias and nep-reg
Note: We wish to thank Dwight Jaffee, William Lang, Wenli Li, Nancy Wallace and James Wilcox for comments, as well as participants at seminars given at the Haas School, the Federal Reserve Banks of Philadelphia and St. Louis, FannieMae, and State Street Corporation.
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