Capital Structure and Competition in the Banking Industry: Theory and Empirics

This paper incorporates the observation that in banking industries, debts are usually affected by current return and cannot be predetermined before competition. In a portfolio choice model, we have analyzed how two banks sequentially decide their capital structures through choosing equity levels, and then the levels of risky investment which is subject to the rival’s competition. Taking equity as control variable gives us a different aspect to examine the impact of banks’ financial decisions; In addition to the impact on the critical value of shock from uncertain demand, the banks’ financial decisions also affect banks’ cash flow reserve, as well as the costs paid to equityholders and debtholders. Our main result agrees with Brander and Lewis’ point that leverage is positively related to a