We propose a general equilibrium theory of bank capitalization. Incomplete markets preclude insurance against capital shortfalls and financial market segmentation implies an imperfectly elastic supply of capital in the short-term. Banks’ individually optimal leverage trades off the endogenous equity premium with better bankruptcy protection for uninsured deposits, but fails to internalize how equity buffers impact the endogenous cost of recapitalizations and, thereby, the incidence of insolvencies. We allow for both, liability and asset side recapitalizations. In equilibrium, under-capitalization and inefficiently frequent insolvencies provide a novel rationale for macroprudential capital regulation that does not rely on moral hazard or informational asymmetries. The model has implications for the communication of stress test results, offers a set of novel testable implications, and makes progress towards a “pecking order theory” of bank recapitalizations.
- Keywords: bank capital, macroprudential regulation, incomplete markets, financial market segmentation, constrained inefficiency.