We study banks’ optimal equity buffer in general equilibrium, as well as their ex-post response to under-capitalization. Developing a “pecking order theory” for private recapitalizations, our benchmark model identifies equity issuance as individually and socially optimal, compared to deleveraging, and conditions that invert the individually optimal ranking. Ex-ante, the imperfectly elastic supply of capital, incomplete insurance markets and costly bankruptcies give rise to inefficiently high capital shortfalls and excessive insolvencies. Abstracting from moral hazard and informational asymmetries, we therefore provide a novel rationale for macroprudential capital regulation emerges and a new set of testable implications about banks’ capital structure management.
- Keywords: bank capital, macroprudential regulation, incomplete markets, financial market segmentation, constrained inefficiency.