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Why High Leverage Is Optimal for Banks

Author

Listed:
  • DeAngelo, Harry

    (University of Southern CA)

  • Stulz, Rene M.

    (OH State University and ECGI)

Abstract
Liquidity production is a central role of banks. When there is a market premium for the production of (socially valuable) liquid financial claims and no other departures from the Modigliani and Miller (1958, MM) assumptions, we show that high leverage is optimal for banks. In this model, high leverage is not the result of distortions from agency problems, deposit insurance, or tax motives to borrow. The model can explain (i) why bank leverage increased over the last 150 years or so without invoking any of these distortions, (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. MM's leverage irrelevance theorem 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 or socially destructive.

Suggested Citation

  • DeAngelo, Harry & Stulz, Rene M., 2013. "Why High Leverage Is Optimal for Banks," Working Paper Series 2013-08, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
    • Handle: RePEc:ecl:ohidic:2013-08
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    References listed on IDEAS

    as
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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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