Authors: Viral V. Acharya, Hamid Mehran, and Anjan Thakor

We consider a model in which banks face two moral hazard problems: 1) asset substitution by shareholders, which can occur when banks make risky, negative net-present-value loans; and 2) managerial rent seeking, the result of bank owners investing in inefficient “pet” projects or shirking in effort. The privately optimal level of bank leverage is neither too low nor too high: It efficiently balances the market discipline that owners of risky debt impose on managerial rent seeking against the asset substitution induced at high levels of leverage. However, when correlated bank failures can impose significant social costs, regulators may bail out bank creditors. Anticipation of this action generates an equilibrium in our model featuring systemic risk, in which all banks choose inefficiently high leverage to fund correlated, excessively risky assets. Leverage can be reduced via a minimum equity capital requirement, which can also rule out asset substitution. But this also compromises market discipline by making bank debt too safe. Optimal capital regulation in this model setting requires that a part of bank capital be unavailable to creditors upon failure so as to retain market discipline and be made available to shareholders only contingent on good performance in order to contain risk taking.