A general equilibrium theory of banks' capital structure

Douglas Gale, Piero Gottardi

    Research output: Contribution to journalArticlepeer-review

    Abstract

    We develop a general equilibrium theory of the capital structures of banks and firms. The liquidity services of bank deposits make deposits a “cheaper” source of funding than equity. In equilibrium, banks pass on part of this funding advantage in the form of lower interest rates to firms that borrow from them. Firms and banks choose their capital structures to balance the benefits of debt financing against the risk of costly default. An increase in the equity of a firm makes its debt less risky and that in turn reduces the risk of the banks who lend to the firm. Hence there is some substitutability between firm and bank equity. We find that firms have a comparative advantage in providing a buffer against systemic shocks, whereas banks have a comparative advantage in providing a buffer against idiosyncratic shocks.

    Original languageEnglish (US)
    Article number104995
    JournalJournal of Economic Theory
    Volume186
    DOIs
    StatePublished - Mar 2020

    Keywords

    • Bank financing
    • Bankruptcy costs
    • Banks firms linkages
    • Capital structure
    • Liquidity

    ASJC Scopus subject areas

    • Economics and Econometrics

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