New York Fed: "A New Idea on Bank Capital"

From the Federal Reserve Bank of New York's Liberty Street Economics blog:

How does any firm decide on its capital structure—how much equity (capital) to use, how much debt? And what does research tell us about why banks have so much more financial leverage than other firms? How does this inform capital regulation? This post provides a fresh perspective on these questions, identifying the forces that shape the privately optimal capital structure choices of banks, the manner in which government safety nets distort these choices, and how capital regulation ought to be redesigned in light of these distortions. In particular, we discuss a novel approach (developed in Acharya, Mehran, and Thakor [2013]) to capital regulation that involves a two-tier capital requirement as well as how such a requirement can enhance banking stability.

Why Do Banks Have High Leverage?
Academic corporate finance enters this debate with the famous Modigliani and Miller (1958) leverage-indifference theorem. In a world without frictions (no taxes, no bankruptcy costs, no deposit insurance or other safety nets), Modigliani and Miller show that the capital structure decision, for a given size of the firm and given asset portfolio composition, doesn’t affect firm value and is thus irrelevant. 

   The real world, of course, looks very different from that of Modigliani and Miller, particularly for banks. The standard argument against applying the Modigliani and Miller theorem to banking is that deposits are a factor of production in banking—banks not only use deposits to make loans but also to provide liquidity and transaction services to depositors. Thus, we should expect banks to be highly levered since deposits are a form of debt. However, with finite (constrained) core deposit supply, it isn’t obvious why banks cannot add large amounts of equity to the deposits they gather, which would allow them to gather all the deposits they can and still achieve high capital ratios....MORE