Bank Debt Regulations: Implications for Bank Capital and Bond Risk

We study how optimal bank capital and bond risk are influenced by deposit insurance, implicit guarantees, depositor preference, asset encumbrance, and bail-in resolution frameworks. We find that these features of bank financing change the optimal amount of bank capital. The net effect on bond debt risk and valuation is small, while the effects on shareholder value and public sector liability value are significant. A gap between optimal capital and required capital represents a cost to shareholders and increases the risk of regulatory arbitrage. Based on a small sample of European banks, we find support for the central model predictions.