Bank Liability Structure

Since the fiduciary duty of bank management is to maximize bank value and not social welfare, we analytically solve for the liability structure that maximizes the value of a bank leveraged by deposits and subordinated debt. Our analysis offers a perspective on privately-rational bank capital structure and its interaction with regulatory environment. Absent deposit insurance and regulatory closure, banks use high leverage. The drivers of bank leverage are the low volatility of bank assets and the income from serving deposits, besides corporate taxes. The optimal level of subordinated debt makes its endogenous default coincide with bank run. In response to deposit insurance and regulatory closure, banks increase their value and leverage by expanding deposits, even if they are charged fair insurance premium. They however reduce subordinated debt to keep endogenous default and regulatory closure concurrent. These optimal responses from banks counteract the objective of regulators in lessening expected bankruptcy loss. ⇤Sundaresan is from the Graduate School of Business at Columbia University. Wang is from the Kelley School of Business at Indiana University. This version is updated on September 25, 2014. It has benefited from suggestions by Mark Flannery, Nengjiu Ju, Anat Admati, Anjan Thakor, and Tobias Adrian. We are grateful for comments by the participants in seminars at the Federal Reserve Bank of New York, University of North Carolina at Charlotte, Georgia State University, University of Washington at Seattle, the Reserve Bank of India, and Indiana University at Bloomington. We also appreciate the feedback from participants in Moody’s Credit Risk Research Conference. 1