The Optimal Capital Structure of Depository Institutions 1,2

One should recognise that, in contrast to a corporate firm, there is an underlying problem in assessing the capital structure of a bank. This problem rests mainly on the lack of clarity on how one could define, let alone determine, the location of the optimal. The reason for this is rooted in the differences in the ways the two types of organisations operate. For instance, while a corporate firm generates income from rendering services and/or selling manufactured products, a simple bank brings in revenues by lending its assets. To further complicate things, the type of borrower also plays a vital role, particularly when regulatory capital constraints are enforced on the lender. It is, therefore, not hard to imagine that for a variety of reasons— namely (1) the fundamental discrepancies between how banks and corporate firms operate and (2) with risk and value management come complex interactions between the lender and borrower (Mason, 1995)—the task of determining the optimal capital structure of a bank, as opposed to that of a corporate firm, is far from trivial. With this in mind, we intend here to add some insight into this process, albeit in a simplistic manner, as we try to (1) describe the mechanics that intertwine a lender and a borrower