ABSTRACT
In this chapter, I discuss the capital structure of a bank. The capital structure of a bank is distinct from a usual firm due to its role of providing liquid securities to investors. A bank issues demand deposits to fulfill this role, as investors can withdraw demand deposits at any time they need. Such withdrawability induces the possibility of a bank run, because creditors may withdraw from their accounts when they anticipate others do so, even if they have no need for liquidity. Reviewing Diamond and Dybvig (1983), I commence by showing that coordination failure among creditors can cause a bank run and that deposit insurance can eliminate the possibility of a bank run. I next focus on a bank’s role of providing monitoring service to investors. Due to its monitoring skill, a bank invests entrepreneurs on behalf of investors. Unfortunately, deposit insurance aggravates this function by raising a bank’s incentive for risk-taking, requiring a regulation that mitigates this problem. Based on Hellmann et al. (2000), I show modulating the funding structure of a bank through capital regulation can mitigate a bank’s excessive risk-taking.
