Why High Leverage is Optimal for Banks

Why High Leverage is Optimal for Banks

Harry DeAngelo, René Stulz

Series number :

Serial Number: 
356/2013

Date posted :

May 01 2013

Last revised :

May 06 2013
SSRN Share

Keywords

  • Bank capital requirements • 
  • leverage • 
  • liquidity

Liquidity production is a central role of banks. When there is a market premium for the production of (socially valuable) liquid financial claims and no other departures from the Modigliani and Miller (1958, MM) assumptions, we show that high leverage is optimal for banks.

In this model, high leverage is not the result of distortions from agency problems, deposit insurance, or tax motives to borrow. The model can explain (i) why bank leverage increased over the last 150 years or so without invoking any of these distortions, and (ii) why high bank leverage per se does not necessarily cause systemic risk. MM?s leverage irrelevance theorem is inapplicable to banks: Because debt-equity neutrality assigns zero weight to the social value of liquidity, it is an inappropriately equity-biased criterion for assessing whether the high leverage ratios of real-world banks are excessive or socially destructive.

Authors

Real name: 
Harry DeAngelo