Asset quality, financing structure, and bank regulations

Abstract

In this paper, we build a model of bank’s optimal financing structure (including leverage and debt maturity) by incorporating the moral hazard problem and investigate the interactions between the bank’s asset quality and financing structure. We find that under certain conditions, the bank tends to choose the asset with the lower quality, financed by only short-term debt (no equity or long-term debt), even if some asset with higher quality is available. This is completely opposite to the optimal choice of the social planner, who chooses the asset with higher quality, financed by long-term debt and a positive level of equity. Implementing liquidity and leverage regulations simultaneously can deal with this problem.