The Optimal Capital Structure of Banks Under Deposit Insurance and Capital Requirements

Capital structure is an important topic in corporate finance, both for practitioners and academic researchers. This paper examines the impact of deposit insurance and capital requirements on the optimal capital structure of banks. The contingent claims model of capital structure is extended to incorporate deposit insurance and capital requirements. Unlike previous studies on the capital structure of banks, our model suggests that there exists an interior optimal capital ratio in the presence of deposit insurance, taxes and a minimum fixed capital ratio. Moreover, a significant financial burden associated with violating capital requirements is needed in order to obtain the interior capital ratio.