Optimal bank leverage and recapitalization in crowded markets

Summary

Focus

We study situations where banks need to swiftly recapitalise and analyse implications for banks' leverage and recapitalisation strategies. An ongoing example is the Covid-19 crisis, in which financial regulators have appealed to banks worldwide to manage their capital buffers wisely. Banks' private leverage choices ahead of such events can differ from what policymakers prescribe as socially optimal. In addition, not all recapitalisation strategies are equally well suited once systemic capital shortfalls arise. We offer a theoretical framework to study both of these issues.

Contribution

The role of bank capital as a buffer is a key motivation for regulatory requirements in the Basel Framework. In addition, following the 2008 GFC, the mitigation of systemic risks with the help of macroprudential tools has received growing attention. We identify the externalities of banks' leverage choices that have systemic implications. We also draw attention to how bank capital regulation can have novel macroprudential aspects, specifically given banks' capital structure management through asset and liability side operations in cases of distress.

Findings

Our general equilibrium model of bank capitalisation with segmented financial markets predicts banks to be inefficiently undercapitalised. This leads to excessive capital shortages during systemic events and causes bank failures. The model further identifies a destabilising effect of asset side recapitalisations at the bank-specific and systemic level when compared with equity issuances. As banks may nevertheless prefer asset side recapitalisations, optimal regulation calls for a combination of leverage requirements and a macroprudential tool that induces banks to recapitalise in a socially optimal way. Our model further provides a rationale for cooperation among national financial regulators in mandatory recapitalisations and macroprudential leverage regulation. Finally, our results can argue for staggered stress tests and against extensive simultaneous testing exercises.

Abstract

We study optimal bank leverage and recapitalization in general equilibrium when the supply of specialized investment capital is imperfectly elastic. Assuming incomplete insurance against capital shortfalls and segmented financial markets, ex-ante leverage is inefficiently high, leading to excessive insolvencies during systemic capital shortfall events. Recapitalizations by equity issuance are individually and socially optimal. Additional frictions can turn asset sales individually but not necessarily socially optimal. Our results hold for different bankruptcy protocols and we offer testable predictions for banks' capital structure management. Our model provides a rationale for macroprudential capital regulation that does not require moral hazard or informational asymmetries.

JEL Codes: D5, D6, G21, G28

Keywords: Bank capital, recapitalization, macroprudential regulation, incomplete markets, financial market segmentation, constrained inefficiency