Bank Capital Structure, Fire Sales, and the Social Value of Deposits

We describe a model in which bank deposits yield liquidity services and therefore earn a lower rate of return than equity. In this sense, deposits are a cheaper source of funding for banks than equity. The banks’ equilibrium capital structure is determined by a trade off between the funding advantages of deposits and the risk of costly default. The cost of default, however, is an illusion associated with the transfer of value in fire sales. This transfer is a private cost for the owners of failed banks but not a deadweight loss for society. As a result, deposits are under-used and banks’ funding costs receive a subsidy from depositors. This subsidy eventually causes banks to grow too large and overaccumulate assets. Policies that force banks to hold higher capital buffers, motivated by a desire to make banks “safer,” will make deposits even cheaper and increase the overaccumulation problem. Increasing leverage, on the other hand, will increase the cost of debt finance and reduce overaccumulation, but may increase the external costs of financial distress, which bankers ignore.