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

Which factor most plausibly explains why a bank's observed optimal equity ratio is higher than a pure tax-shield trade-off model would suggest, even though deposit insurance is subsidized?

Distress costs, binding regulatory minimum capital and the need to keep funding providers confident raise the cost of thin capital. These offset the tax shield and safety-net subsidy, so observed equity ratios are higher than a simple tax-shield model would predict.

  1. AEquity holders prefer lower returns
  2. BExpected costs of financial distress, regulatory minimum capital requirements and the need to retain market confidence in fundingCorrect
  3. CDeposits carry no interest cost
  4. DTaxes are not levied on banks anywhere

Explanation

Trade-off theory balances the tax shield and funding subsidies against distress costs. For banks, regulatory minimums and confidence-sensitive funding add to the cost of low capital, pushing equity ratios up. The other options are factually wrong.

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