Financing as a Supply Chain

The following post comes to us from Will Gornall and Ilya Strebulaev, both of the Finance Area at Stanford University.

In our recent NBER working paper, Financing as a Supply Chain: The Capital Structure of Banks and Borrowers, we propose a novel framework to model joint debt decisions of banks and borrowers. Our framework combines the models used by bank regulators with the models used to explain capital structure in corporate finance. This structure can be used to explore the quantitative impact of government interventions such as deposit insurance, bailouts, and capital regulation.

We find that bank and borrower financial decisions are intertwined through a number of mechanisms. Costly bank distress means that high bank leverage pushes firm leverage down and vice versa. At the same time, a highly levered bank is better able to pass along the tax benefits of debt, raising the debt of both banks and firms. These two supply chain mechanisms are accentuated by the bank’s ability to diversify and bank debt being senior to equity and commonly senior to other forms of debt. High bank leverage and low firm leverage emerge naturally from this strategic interaction. With our benchmark parameters, firm leverage is 37%, while bank leverage is 88%, not dissimilar to what we observe empirically.

Our model allows us to quantify the impact of deposit insurance and bailouts on bank risk taking. We find that small probabilities of bailouts and moderate levels of deposit insurance have only marginal effects on bank risk taking, but there is a tipping point beyond which expectations of intervention lead banks to take on dramatically more risk. Many banks have enough insured deposits to face such extreme moral hazard.

Capital regulation can be effective at reducing moral hazard but is subject to substantial model risk. By inappropriately capturing borrower risk, some forms of capital regulation can make banks misprice risk and lead to excessive borrower defaults. Capital regulation that is subject to gaming, as we argue Basel II and III may be, is ineffective at preventing moral hazard.

Strong, targeted capital regulation increases efficiency. Banks funded primarily with insured deposits or banks that are defacto too-big-to-fail should face tighter capital regulation. We calculate the costs of capital regulation as modest—increasing bank equity requirement by 1% increases borrower cost by 1.5 basis points—which suggests capital regulation could be substantially strengthened without undue economic harm. Current capital requirements may be insufficient. We find that a 16% equity requirement using a Basel-style IRB formula produces substantial efficiency gains by reducing bank defaults and forcing banks to better price systemic risk.

Obviously, we have just scratched the surface of these issues. Regulators, academics, and practitioners continue to have a discussion on bank capital structure, systemic risk, and capital regulation. The framework we present is rich and flexible enough to address many of the unanswered questions about these issues.

The full paper is available for download here.

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