No. 10/2013: Bank Debt Regulations: Implications for Bank Capital and Bond Risk
Abstract
We use a structural model of default risk to study how optimal bank
capital and bond risk are influenced by deposit insurance, implicit guarantees, depositor preference, asset encumbrance, and bail-in resolution
frameworks. We find that these features of bank financing, in addition to having an immediate impact on bond debt risk, also change optimal
bank capital, countering the first-order effect on bond debt risk. Bondholders' risk is thereby not materially affected, but shareholder
value and public sector value are. A gap between optimal capital and required capital represents a cost to shareholders, and increases the
risk of regulatory arbitrage. Enhancing capital requirements, and at the same time adopting bank debt regulations that reduce the optimal
capital, is to gain some and lose some in terms of financial stability. Based on a small sample of European banks, we find support for the
central model predictions.
JEL Classification: G21, G28, G32.
Keywords: Bank debt regulations, optimal bank capital, bond risk.