We construct a model of bank’s financing under moral hazard. The bank borrows funds to acquire risky assets, and is able to choose (or to change) the riskiness of its assets after the borrowing is done, which is the source of the moral hazard. We ignore deposit insurance, and focus on uninsured bank debt. The moral hazard leads to an excessive level of risk. We show that short-term debt may act as a discipline device when creditors observe some interim signal of the bank’s risk. However, if the signal is noisy short-term debt may lead to inefficient liquidation, so there is a trade-off. We characterize the conditions under which long-term debt and short-term debt (both safe and risky) are feasible, and show that risky short-term debt may be the only way to secure funding and that it may dominate long-term debt (when the latter is feasible).

The views expressed are those of the individual author(s) and do not necessarily reflect official positions of the Office of Thrift Supervision or the U.S. Treasury.

The recent financial crisis has triggered a rethinking of the supervision and regulation of systemic connectedness. While there is a clear need to take a multipronged approach to systemic risk, and a flood of regulatory reform proposals has ensued, there is considerable uncertainty about how those proposals can be practically applied. Thus, this chapter aims to contribute to the debate on systemic-risk-based regulation in two ways. First, it presents a methodology to compute and smooth a systemic-risk-based capital surcharge. Second, it formally examines whether a mandate, by itself, to explicitly oversee systemic risk, as envisioned in some recent proposals, is likely to be successful in mitigating it. Systemic-Risk-Based Surcharges While not necessarily endorsing the adoption of systemic-based capital surcharges, the first part of the chapter presents a methodology to calculate such surcharges. Underpinning this methodology is the notion that these surcharges should be commensurate with the large negative effects that a financial firm’s distress may have on other financial firms—their systemic interconnectedness. The chapter presents two approaches to implement this methodology: • A standardized approach under which regulators assign systemic risk ratings to each institution and then assess a capital surcharge based on this rating.

the DIECOFIS Consortium, ISTAT, and the Ministry for Industry and Trade, Italy. The views expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any errors are the author’s responsibility. 1 There are conflicting interpretations of economic growth, both over longer periods and recently. In this paper, I discuss one aspect of evidence presented in more detailed analyses of economic growth by myself with co-authors [Baier, Dwyer and Tamura 2002, 2003], namely the roles of physical and human capital and everything else. “Everything else ” is called “total factor productivity ” (TFP), which suggests part of what’s correct: TFP includes the productivity of resources not reflected in physical and human capital matters. TFP changes for additional reasons than discovery of new ways of generating output, including institutional innovation and changes, government regulation, and more. While Italy is not typical, I examine Italy relative to Western Countries and Southern Europe in part because the divergences are informative and in part because this talk is being given in Italy. I also make some observations about the recent resurgence in economic growth in the United States and other countries. I was asked to give a talk about recent economic growth from a “U.S. perspective. ” I interpreted a “U.S. perspective ” as an analysis from the point of view of someone living in the United States, not solely an analysis of the United States. As a result, you will find little focus on the United States ’ recent experience, although my perspective on the Digital Revolution is shaped by my personal experiences in the United States. Indeed, it may be seriously biased because I know much more about recent economic growth in the United States than in the rest of the world. Don’t misinterpret me: I know much less about recent economic growth in the U.S. than I would like. I just know more about the U.S. than the rest of the world. 2

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the problems and opportunities facing the financial services industry in its search for competitive excellence. The Center's research focuses on the issues related to managing risk at the firm level as well as ways to improve productivity and performance. The Center fosters the development of a community of faculty, visiting scholars and Ph.D. candidates whose research interests complement and support the mission of the Center. The Center works closely with industry executives and practitioners to ensure that its research is informed by the operating realities and competitive demands facing industry participants as they pursue competitive excellence. Copies of the working papers summarized here are available from the Center. If you would like to learn more about the Center or become a member of our research community, please let us know of your interest.

This paper supercedes "Safety in Numbers? Geographic Diversification and Bank Insolvency

Abstract: Although financial instruments that, in effect, permit corporations to treat preferred stock dividends as tax-deductible interest have been used by nonfinancial corporations since late 1993, bank holding companies (BHCs) did not issue these trust-preferred securities (TPS) until 1996, when the Federal Reserve qualified them as Tier-1 capital. We delineate and test hypotheses with 1) analyses of the stock-market reaction to the Fed’s ruling and to TPS filings and 2) comparisons of BHCs that issued TPS with those that did not. We conclude that regulatory capital requirements, tax savings, and uninsured sources of funds can have significant positive effects on BHCs ’ demand for capital; growth and investment opportunities have an inconclusive effect; and transaction costs have a negative effect. Our results are not consistent with the moral-hazard hypothesis. JEL classification: E5, G2, L1, L5 Key words: bank capital structure, bank holding companies, regulatory capital, securities innovations, Tier-1 capital, trust-preferred securities The authors thank Michael Padhi of the Federal Reserve Bank of Atlanta for his assistance in obtaining financial data for bank holding companies; Christopher Gastelu of Ryan, Beck & Co., Livingston, New Jersey, for providing data on trustpreferred transactions by community banks and thrift institutions; John Connolly, Robert Eisenbeis, Jocelyn Evans, Ramon

Liquidity risk, liquidity creation and financial fragility: A theory of banking

We extend the literature on the effects of managerial entrenchment to consider how safety-net subsidies and financial distress costs interact with managerial incentives to influence capital structure in U.S. commercial banking. Using cross-sectional data on publicly traded, highest-level U.S. bank holding companies, we find empirical evidence of Marcus ’ proposition (1984) that there are dichotomous strategies for value maximization—one involving relatively higher financial leverage and the other, lower financial leverage. We find that a less levered capital structure is associated with higher charter value and vice versa. Moreover, differences in charter value result in dichotomous strategies for managerial entrenchment: under-performing, less levered firms hold too little capital while under-performing, more levered firms hold too much.