Bank Leverage, Welfare, and Regulation

Abstract

We take issue with claims that the funding mix of banks, which makes them fragile and crisis-prone, is efficient because it reflects special liquidity benefits of bank debt. Even aside from neglecting the systemic damage to the economy that banks’ distress and default cause, such claims are invalid because banks have multiple small creditors and are unable to commit effectively to their overall funding mix and investment strategy ex ante. The resulting market outcomes under laissez-faire are inefficient and involve excessive borrowing, with default risks that jeopardize the purported liquidity benefits. Contrary to claims in the literature that “equity is expensive” and that regulation requiring more equity in the funding mix entails costs to society, such regulation actually helps create useful commitment for banks to avoid the inefficiently high borrowing that comes under laissez-faire. Effective regulation is beneficial even without considering systemic risk; if such regulation also reduces systemic risk, the benefits are even larger. September 27, 2018, revised January 23, 2019

Keywords: Liquidity in banking, leverage in banking, banking regulation, capital structure, capital regulations, agency costs, commitment, contracting, maturity rat race, leverage ratchet effect, Basel

JEL Classification: D004, D53, D61, G01, G18, G21, G24, G28, G32, G38, H81, K23