The Optimal Capital Structure of an Economy - Workshop "Basel II: An Economic Assessment" - May 2002

In a general equilibrium model we examine the optimal allocation of equity and debt across banks and industrial rms when both are plagued by incentive problems and rms can borrow from banks. Increasing bank equity mitigates bank-level moral hazard but may exacerbate rm-level moral hazard due to dilution of rm equity. Competition of banks will not result in a socially e cient level of equity. Imposing capital requirements on banks can trigger the socially optimal capital structure of an economy in the sense of maximizing aggregate output. Such capital regulation is second-best and must balance three costs: excessive risk taking of banks, credit restrictions banks impose on rms with low equity, and credit restrictions because of high loan interest rates.