Making Bank: Why High Bank Leverage is Optimal For the Bank's Shareholders

Abstract

High bank leverage is commonly considered a major threat to financial stability. We build a structural credit model to calculate the optimal leverage for a bank that provides asset backed loans, such as corporate loans and mortgages. The bank’s assets are loans, which means that the bank’s exposure to risk is mitigated by the borrower’s equity. We capture the effect of this mitigation by including the borrower’s leverage, in addition to its asset volatility, as the sources of risk for the bank. Our results contribute a quantitative explanation for the high levels of observed bank leverage. When unconstrained by regulation, the bank’s shareholders find it optimal, for reasonable values of borrower risk parameters, to select a bank leverage close to 100%.