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FRM Part II · FRM Exam Part II · Capital Structure in Banks

Which factor is most likely to cause a bank's observed optimal capital structure to include much higher leverage than an otherwise identical non-financial firm's, even though the bank's shareholders do not gain from leverage in an MM world?

Deposit insurance and implicit government guarantees reduce banks' funding costs below what their risk would justify, and interest tax deductibility adds a further benefit. These frictions give shareholders an incentive for high leverage, unlike in the frictionless MM world.

  1. ADeposit insurance and implicit government guarantees that subsidise the bank's cost of debt, together with the tax shield on interestCorrect
  2. BHigher bankruptcy costs for banks than for non-financial firms
  3. CLower asymmetric information between bank managers and outside investors
  4. DA higher cost of equity for banks, arising from their lower asset volatility

Explanation

Safety-net subsidies make debt funding cheaper than its risk warrants, and interest is tax deductible, so shareholders capture value from leverage. Higher bankruptcy costs would push leverage lower, and the other options do not explain high leverage.

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