Regulatory Taxes, Investment, and Financing Decisions for Insured Banks

This article develops a two-factor model of bank behavior under credit and interest rate risk. In addition to flat-rate government deposit guarantees, we assume banks possess charter values that are lost if audits reveal that their tangible assets cannot cover their liabilities. Within this framework, we investigate the effects of interest rate and credit risk on optimal capital structure and investment decisions. We then show that with no uncertainty in interest rates, capital regulation will reduce the risk of the assets in the bank. However, with interest rate uncertainty, the impact of regulation may be detrimental and raise the risk of the deposits as well as the government subsidies to the shareholders of the bank.