Bank's capital structure under non-diversifiable risk (Q1865201)

The aim of this paper is to study the design of optimal capital structure of a ``large'' intermediary when there is a non-diversifiable risk. It is assumed that the cost of verifying an intermediary is constant, irrespective of the bank size. The author demonstrates that under some conditions a ``large'' intermediary realizes more efficient allocation by issuing both debt and equity than by issuing only debt. The set of optimal contracts involves ex ante monitoring made by shareholders of the intermediary. It is proved that the changes in parameters, such as the variance of the aggregate risk or the cost of monitoring, affect bankruptcy costs and the capital structure. A two-period model is considered. In period \(0\) agents write contracts, and in period \(1\) consumption takes place. Mathematically, the problem is rdeuced to a two-sided optimization procedure in a stochastic environment. Possible extensions are described.