Equity, debt and moral hazard: the optimal structure of banks’ loss absorbing capacity

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 27 July 2018

Staff Working Paper No. 745
By Misa Tanaka and John Vourdas

This paper develops a model to analyse the optimal ex-ante capital and total loss absorbing capacity (TLAC) requirements, and the ex-post resolution policy of banks. Banks in our model are subject to two types of moral hazard: i) ex-ante, they have the incentive to shirk on project monitoring, thus increasing the risk of failure, and ii) ex-post, poorly capitalised banks have the incentive to engage in asset substitution by ‘gambling for resurrection’. Ex-ante moral hazard can be eliminated by ensuring that banks have sufficient capital and uninsured ‘bail-inable’ debt, while ex-post moral hazard is mitigated by triggering resolution when the minimum capital requirement is breached. We argue that optimal regulation consists of a high TLAC requirement and high capital buffer. Our analysis also suggests that higher system-wide risk would call for a higher capital buffer, but TLAC could be lowered if it does not jeopardise the credibility of bail-in itself.

PDFEquity, debt and moral hazard: the optimal structure of banks’ loss absorbing capacity

 

Other papers

Was this page useful?
Add your details...