Three essays on the capital structure and risk exposure of banks under deposit insurance and capital requirements

Date of Completion

January 2006


Economics, Finance




Capital structure is an important topic in corporate finance both for practitioners and academic researchers. This dissertation examines the impacts of deposit insurance and capital requirements on the optimal capital structure of banks. The first chapter develops a static model with one uncertainty source using the contingent claims approach. The classical model of corporate capital structure using the contingent claims approach is extended to incorporate deposit insurance and capital requirements for the capital structure of banks. The model suggests that there exists an interior optimal capital ratio in the presence of deposit insurance, taxes and a sufficiently stringent minimum capital standard.^ The second chapter examines the Value at Risk (VaR) based risk exposure for banks and the corresponding costs for regulators. A closed-form solution of VaR is provided based on the valuation results in the first chapter. It is found that banks can offset the risk associated with volatile assets by choosing a suitable proportion of debt. In addition, banks may shift risk to deposit insurance to decrease their own risk exposure under less stringent capital requirements. Being a risk lover does not stop banks from shifting risk to deposit insurance. Regulators can lower down banks risk exposure by imposing more stringent capital requirements.^ The third chapter provides a framework to examine the impact of interest rate risk on the bank capital structure. Three models are used to study two cases in which banks do not match deposit rates to the risk-free interest rate, and one case in which banks adjust deposit rates to the changes in the risk-free interest rate. Moreover, the model is extended to incorporate the risk associated with rare events captured by a jump process. The results imply that both interest rate risk and rare event risk play a critical role in the optimal capital structure of banks. The results of VaR show that the overall risk is highly related to the bank capital structure policy. Monte Carlo simulation is applied to the capital structure problem and the VaR calculation.^