Financing as a Supply Chain: The Capital Structure of Banks and Borrowers

Financing as a Supply Chain: The Capital Structure of Banks and Borrowers

By
Will Gornall, Ilya A. Strebulaev
Journal of Financial Economics. September
2018, Vol. 129, Issue 3, Pages 510-530

We develop a model of the joint capital structure decisions of banks and their borrowers. Bank leverage of 85% or higher emerges because bank seniority both dramatically reduces bank asset volatility and incentivizes risk-taking by producing a skewed return distribution. Nonfinancial firms choose low leverage to protect their banks, presenting a partial resolution to the low-leverage puzzle. Our setup naturally extends to include government actions as we model bank assets using a modified Basel framework. Deposit insurance and bailout expectations lead banks and borrowers to take on more risk. Capital regulation lowers bank leverage but can increase bank risk due to a compensating increase in borrower leverage. Despite this, doubling current capital requirements reduces bank default risk by up to 90%, with only a small increase in loan interest rates.