Caught between Scylla and Charybdis? Regulating Bank Leverage When There is Rent Seeking and Risk Shifting

Caught between Scylla and Charybdis? Regulating Bank Leverage When There is Rent Seeking and Risk Shifting

Viral Acharya, Hamid Mehran, Anjan Thakor

Series number :

Serial Number: 
365/2013

Date posted :

September 01 2015

Last revised :

June 28 2013
SSRN Share

Keywords

  • market discipline • 
  • asset substitution • 
  • systemic risk • 
  • bailout • 
  • forbearance • 
  • moral hazard • 
  • capital requirements
We develop a theory of optimal bank leverage in which the benefit of debt in inducing loan monitoring is balanced against the benefit of equity in attenuating risk-shifting. However, faced with socially-costly correlated bank failures, regulators bail out creditors. Anticipation of this generates multiple equilibria, including one with systemic risk in which banks use excessive leverage to fund co
rrelated, inefficiently risky loans. Limiting leverage and resolving both moral hazards?insufficient loan monitoring and asset substitution?requires a novel two-tiered capital requirement, including a ?special capital account? that is unavailable to creditors upon failure.

Authors

Real name: 
Fellow, Research Member
Leonard N. Stern School of Business, New York University
Real name: 
Hamid Mehran
Real name: 
Research Member
John M. Olin School of Business, Washington University, St. Louis