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Why High Leverage is Optimal for Banks

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  • Harry DeAngelo
  • René M. Stulz

Abstract

Liquidity production is a central role of banks. We show that, under idealized conditions, high leverage is optimal for banks when there is a market premium for (socially valuable) liquid financial claims and no deviations from Modigliani and Miller (1958) due to agency problems, deposit insurance, taxes, or any other distortions. Our model can explain (i) why bank leverage increased over the last 150 years or so, (ii) why high bank leverage per se does not necessarily cause systemic risk, and (iii) why limits on the leverage of regulated banks impede their ability to compete with unregulated shadow banks. Our model indicates that MM's debt-equity neutrality principle is inapplicable to banks. Because debt-equity neutrality assigns zero weight to the social value of liquidity, it is an inappropriately equity-biased baseline for assessing whether the high leverage ratios of real-world banks are excessive.

Suggested Citation

  • Harry DeAngelo & René M. Stulz, 2013. "Why High Leverage is Optimal for Banks," NBER Working Papers 19139, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:19139
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers
    • G01 - Financial Economics - - General - - - Financial Crises
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • L51 - Industrial Organization - - Regulation and Industrial Policy - - - Economics of Regulation

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