Bank Capital Structure and Tail Risk (Work in progress)
Abstract: This paper presents a bank capital structure model in which the bank’s assets are subject to both diffusion and tail risk. The latter causes uninsured deposits to be risky, as the bank’s asset value can fall below the value of deposits. The model shows that tail risk, rather than diffusion risk, is the main driver of the risk on deposits when the bank is unregulated and of the endogenous deposit insurance premium when the bank is regulated. Keeping total volatility constant, the model shows that an increase in tail risk leads to higher credit spreads and default risk than an increase of diffusion risk.