New BIS Working Paper No. 923 “Optimal Bank Leverage and Recapitalization in Crowded Markets”

“Optimal Bank Leverage and Recapitalization in Crowded Markets” with Mike Mariathasan (BIS Working Paper No. 923, January 2021; Builds on older paper “Fire Sale Bank Recapitalizations”: 09/2015)

  • Abstract: We study optimal bank leverage and recapitalization in general equilibrium when the supply of specialized investment capital is imperfectly elastic. Assuming incomplete insurance against capital shortfalls and segmented financial markets, ex-ante leverage is inefficiently high, leading to excessive insolvencies during systemic capital shortfall events. Recapitalizations by equity issuance are individually and socially optimal. Additional frictions can turn asset sales individually but not necessarily socially optimal. Our results hold for different bankruptcy protocols and we offer testable predictions for banks’ capital structure management. Our model provides a rationale for macroprudential capital regulation that does not require moral hazard or informational asymmetries. (D5, D6, G21, G28)
This figure depicts for a given level of leverage (horizontal axis) the market-clearing price for specialized investment capital and the threshold level of bank portfolio risk below which liability side recapitalizations (red) and asset side recapitalizations (blue) are feasible.
  • Keywords: bank capital, recapitalization, macroprudential regulation, incomplete markets, financial market segmentation, constrained inefficiency.
  • Also available as Riksbank Working Paper No. 312

Revised version of “Fire Sale Bank Recapitalizations”

“Optimal Bank Capitalization in Crowded Markets” with Mike Mariathasan (KU Leuven)
(This version: 08/2017; First version: 09/2015; Sveriges Riksbank Working Paper No. 312)

  • Abstract:

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.

New paper on “Fire Sale Bank Recapitalizations”; Sveriges Riksbank Working Paper Series No. 312

“Fire Sale Bank Recapitalizations” with Mike Mariathasan (KU Leuven) (This version: Sept. 2015; First version: Sept. 2015)

  • Abstract:

We develop a general equilibrium model of banks’ capital structure, featuring heterogeneous portfolio risk and an imperfectly elastic supply of bank equity stemming from financial market segmentation. In our model, equity is costly and serves as a buffer against costly bankruptcy. Banks are ex-ante identical, but may need to recapitalize by selling equity claims after their portfolio risk becomes public knowledge. When the need to issue outside equity arises simultaneously in a large number of banks, the market for equity becomes crowded. Reminiscent of asset fire sales, banks do not fully internalize the effect of their individual equity issuance on the endogenous cost of equity and their future ability to recapitalize. As a result, they are under- capitalized in equilibrium, and the incidence of insolvency is inefficiently high. This constrained inefficiency provides a new rationale for macroprudential capital regulation that arises despite the absence of deposit insurance and moral hazard; it also has implications for the regulation of payout policies and the design of bank stress testing.

  • Keywords: macroprudential policy, capital regulation, capital structure, financial market segmentation, incomplete markets, constrained inefficiency.