The capital structure and regulation of financial intermediaries is an important
topic for practitioners, regulators and academic researchers. In general, theory
predicts that firms choose their capital structures by balancing the benefits of
debt (e.g., tax and agency benefits) against its costs (e.g., bankruptcy costs).
This paper studies the impact and interaction of deposit insurance, capital requirements
and tax benefits on a bank's choice of optimal capital structure. Using a contingent
claims model to value the firm and its associated claims, we find that there exists
an interior optimal capital ratio in the presence of deposit insurance, taxes and
a minimum fixed capital standard as long as there is a significant financial burden
associated with violating capital requirements. Banks voluntarily choose to maintain
capital in excess of the minimum required in order to balance the risks of insolvency
(especially to future tax benefits) against the benefits of additional debt. Because
our model includes all three contingent claims, our results differ from those of
previous studies of the capital structure of banks that have generally found corner
solutions (all equity or all debt) to the capital structure problem.