A General Equilibrium Theory of Capital Structure∗

We develop a general equilibrium theory of the capital structures of banks and firms. The liquidity services of bank deposits make deposits a “cheaper” source of funding than equity. Banks pass on part of this funding advantage in the form of lower interest rates to firms that borrow from them. Firms and banks choose their capital structures to balance the funding of debt against the risk of costly default. Firm equity is a substitute for bank equity. An increase in a firm’s equity makes the firm’s debt less risky and that in turn reduces the risk of the bank’s portfolio. Firms have a comparative advantage in providing a buffer against systemic shocks, whereas banks have a comparative advantage in providing a buffer against idiosyncratic shocks.