Scandinavian Working Papers in Economics

Discussion Papers,
Norwegian School of Economics, Department of Business and Management Science

No 2015/33: Making Bank: Why High Bank Leverage is Optimal - for the Bank's Shareholders

Nikhil Atreya (), Aksel Mjøs () and Svein-Arne Persson ()
Additional contact information
Nikhil Atreya: Dept. of Business and Management Science, Norwegian School of Economics, Postal: NHH , Department of Business and Management Science, Helleveien 30, N-5045 Bergen, Norway
Aksel Mjøs: Dept. of Business and Management Science, Norwegian School of Economics, Postal: NHH , Department of Business and Management Science, Helleveien 30, N-5045 Bergen, Norway
Svein-Arne Persson: Dept. of Business and Management Science, Norwegian School of Economics, Postal: NHH , Department of Business and Management Science, Helleveien 30, N-5045 Bergen, Norway

Abstract: We create a structural credit model to calculate the optimal capital structure 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 bank leverage observed in practice. 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%.

Keywords: Structural credit model; optimal capital structure; asset backed loans

JEL-codes: G00; G21

37 pages, November 27, 2015

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