Optimal Bank Leverage and Recapitalization in Crowded Markets

Abstract

We study optimal bank leverage and recapitalization in general equilibrium when the sup- ply of specialized investment capital is imperfectly elastic. Assuming incomplete insurance against capital shortfalls and segmented financial markets, ex-ante leverage is inefficiently high, leading to excessive insolvencies during systemic capital shortfall events. Recapitalizations by equity issuance are individually and socially optimal. Additional frictions can turn asset sales individually but not necessarily socially optimal. Our results hold for different bankruptcy protocols and we offer testable predictions for banks’ capital structure management. Our model provides a rationale for macroprudential capital regulation that does not require moral hazard or informational asymmetries.

Keywords: bank capital, recapitalization, macroprudential regulation, incomplete markets, financial market segmentation, constrained inefficiency

JEL Classification: D5, D6, G21, G28