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.
Abstract: This paper presents a bank capital structure model in which equity holders can increase asset risk once debt is in place. I study the effects of capital requirements and subsidized deposit insurance on the bank’s privately optimal funding and operational risk level. The model predicts that there are synergetic effects of regulation and market discipline. When the regulator sets the capital charge and deposit insurance premium payments sufficiently high for a risky portfolio, the bank commits to the low-risk asset portfolio by setting a lower leverage ratio. This market discipline effect disappears when the regulatory costs become too high.
Dividend Restrictions and Asymmetric Information (2021) with Mads Nielsen (Université de Lausanne)
Abstract: We develop a dynamic model of banks whose insiders have superior information about the impact of a pending shock to the bank’s cash holdings and can signal the bank’s type through its dividend policy. Banks that will be adversely affected by the shock have incentives to pool with banks that are not exposed to the liquidity shock in order to increase their market value. To avoid being mimicked, the less fragile banks can credibly signal via a more aggressive payout strategy. Dividend payout restrictions have the potential to prevent a separating equilibrium from forming. This could lead to the bad type banks having a more aggressive payout policy and an increased default probability than in the absence of a dividend restriction.