Regulating Bank Capital Structure to Control Risk

T he most important recent developments in bank regulation are based on capital requirements. For example, the Basle Accord of 1988 specifies that bank capital must be at least 8 percent of a bank’s risk-weighted assets.1 Also, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) requires regulators to shut down a bank whose capital has dropped below a cutoff level. While these regulations are important, their focus is too narrow in that they concentrate solely on equity. There are other types of financial instruments available, and these can be even more effective than capital requirements at controlling risk. Proposals to require banks to issue subordinated debt recognize this, but even those proposals do not make full use of the possibilities available. This article argues that capital regulation can be improved by using financial instruments like convertible debt and warrants with high strike prices. Furthermore, some of the improvement brought about by these instruments would allow a reduction in the traditional capital requirements. Any economic study of bank capital regulation requires a theory of capital structure. Modern theories of corporate financial structure start with the celebrated result of Modigliani and Miller (1958): that in a world without taxes or bankruptcy costs, the value of a firm does not depend on its capital structure. These theories then consider departures from the world of Modigliani and Miller—departures that cause the capital structure to matter. The particular departure studied in this article is agency theory. In the agency theory of capital structure, limited liability creates an incentive for highly leveraged firms to take excessive risk. These incentives are made worse in banking because