Optimal bank capital: a trade – off corporate finance perspective

In this paper I model the effect of costs and benefits of having equity on the bank weighted average cost of capital (WACC). Adopting a trade – off corporate finance perspective, costs are related to the loss in present value of debt tax shields and liquidity premium, while benefits are related to the reduction of bank failure probability. The distress effect is incorporated into the bank WACC through the “Cost of leverage” model of Fernandez (2002, 2007), adjusted for the liquidity premium level and for different bank debt policies. Incorporating the cost and benefits on overall cost of bank funding and together with the use of Merton (1974) model, I am able to obtain numerically the optimal level of bank capital, and capital requirements as a whole, for several firm specific and country characteristics (asset volatility, risk-free rate, debt maturity, tax rate, liquidity premium level). A trade off – based framework consistent with traditional corporate finance, presenting results in line with previous literature on bank capital requirements, supports both stability and individual bank value maximization.