Bank Liability Structure Suresh Sundaresan Zhenyu Wang

Bank Balance Sheet Assets Liabilities Loans and Securities: V Deposits (insured): D (generate cash flows but can be risky and volatile) Non-deposit liabilities: B Equity: E Deposits are cheap, and provide tax advantages. Non-deposit liabilities are more expensive, but also provide tax benefits. When bank capital is “too low”, resolution authorities will shut down the bank (and arrange transfer of assets and liabilities) to protect depositors. Bank provides both maturity and liquidity transformation.

Bank Balance Sheet Assets Liabilities Loans and Securities: V Deposits (insured): D (generate cash flows but can be risky and volatile) Non-deposit liabilities: B Equity: E We assume a depositor preference. Deposit insurance premium is endogenous: The bank’s choice of D affects the insurance premium. The insurance premium affects the bank’s choice of D, which affects the choice of B. We capture this feedback effect. Regulatory Closure depends on Tier 1 + Tier 2 capital. This gives an additional positive role for non-deposit liabilities. 4. Bank chooses D and B to maximize the total value.

Deposit Insurance and deposit preference In 1993, Congress instituted depositor preference nationwide. The law states that when banks fail, deposit liabilities are to receive priority over general trade claims (unsecured creditors and equity). Since April 2011, the FDIC has changed the assessment base to be the difference between the risk-weighted assets and the tangible equity, as required by the Dodd- Frank Act (Section 331). In our model, the new assessment base equals D + B, which implies that assessment rate is b such that I = b(D + B). The actual premium assessment may also depend on the credit rating and how the deposits are protected by the non-deposit debt. Sources: The Liability Structure of FDIC-Insured Institutions: Changes and Implications by Christine M. Bradley and Lynn Shibut (2006) And Federal Deposit Insurance Corporation (2011).

Deposit Insurance and Risk category of banks

Banks’ Optimal Default Policy Value maximizing banks choose D and B so that its endogenous default coincides exactly with the regulatory closure. With this optimal choice of liability structure, the distance to default is the same as the distance to regulatory closure. This optimal structure of liabilities maximizes the tax benefits of debt and minimizes the protection for the deposits. Deposits are cheaper than non-deposit debt as financing sources. Banks should generally prefer deposits to non-deposit debt when balancing the benefits of non-deposit debt against the potential bankruptcy loss. However, the non-deposit debt does not affect bankruptcy risk as long as the endogenous default does not happen before the regulatory closure. So the bank issues as much non-deposit debt as possible for availing of the tax benefits but avoid making a default happen before the regulatory closure.

Deposit Insurance Premium and Liability Structure The deposit insurance corporation essentially sets the expected present value of the insurance premium paid to the insurance corporation equal to the expected present value of the insurance obligations at the bank closure. Bank takes into account the insurance premium in choosing its leverage. FDIC sets the premium taking into account the endogenous leverage and liability structure of the bank, and its dependence on the insurance premium.

Effects of Liquidity Transformation Greater liquidity preference leads to higher leverage

Effects of Liquidity Transformation Greater liquidity preference leads to insurance premium

Effects of Riskiness of Bank Assets Greater asset risk leads to higher credit spreads and Insurance premium.

Effects of Riskiness of Bank Assets Greater asset risk leads to lower leverage, and much Lower non-deposit liabilities.

Effects of Minimum Capital Requirements Higher minimum capital requirements leads to greater Use of non-deposit (Tier 2) capital and lower deposits.

Effects of Minimum Capital Requirements Higher minimum capital requirements lead to lower Credit spreads and insurance premium.

Effects of Insurance Premium Subsidy Insurance subsidy leads to a higher leverage, and greater use of deposits.

Effects of Insurance Premium Subsidy Insurance subsidy leads to higher credit spreads.

Effects of Taxes Lowering taxes, leads to better capitalized banks. Deposits are more preferred than non-deposit liabilities.

Some Extensions We now require the Tier 1 + Tier 2 Capital to fall to a low threshold before the regulators shut down the bank. This gives an important additional role for non-deposit debt. Hence the bank issues more of it than we see in the data. If a minimum Tier 1 capital is imposed, then our model would predict a a greater reliance on deposits and less of a reliance on non-deposit liabilities. We are extending the model to reflect this. We can allow for asset prices to jump causing sudden losses. We expect: Insurance premium to go up. Banks’ liability structure and leverage to reflect this possibility. This is a part of ongoing research.

Summary and Conclusions Our model sheds light on the regulatory treatment of long-term debt. If long-term debt is a claim ranked lower than the deposits, it is naturally viewed as a capital that protects the deposits. Reflecting this view, regulators treat certain long-term unsecured debt as Tier 2 regulatory capital. However, if a bank adjusts its liability structure so that the endogenous default coincides with the regulatory closure, the long-term debt held by the bank do not offer more protection than the minimum capital requirement. Our model predicts that when tax rates fall: Bank becomes less levered, and rely more on deposits.