Business Intelligence

Caught Between Scylla And Charybdis? Regulating Bank Leverage When There Is Rent Seeking And Risk Shifting

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Executive Summary

Banks face two moral hazard problems: asset substitution by shareholders (e.g., making risky, negative net present value loans) and managerial rent seeking (e.g., investing in inefficient "Pet" projects or simply being lazy and un-innovative). The privately-optimal level of bank leverage is neither too low nor too high: it balances efficiently the market discipline imposed by owners of risky debt on managerial rent-seeking against the asset-substitution induced at high levels of leverage. However, when correlated bank failures can impose significant social costs, regulators may bail out bank creditors.

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