A general equilibrium theory of banks capital structure Abstract   We develop a general equilibrium theory of the capital structures of banks and firms. The liquidity services of bank deposits make deposits a xe2x80x9ccheaperxe2x80x9d source of funding than equity. In equilibrium, banks pass on part of this funding advantage in the form of lower interest rates to firms that borrow from them. Firms and banks choose their capital structures to balance the benefits of debt financing against the risk of costly default. An increase in the equity of a firm makes its debt less risky and that in turn reduces the risk of the banks who lend to the firm. Hence there is some substitutability between firm and bank equity. We find that firms have a comparative advantage in providing a buffer against systemic shocks, whereas banks have a comparative advantage in providing a buffer against idiosyncratic shocks.

Cycles of Credit Expansion and Misallocation: The Good, The Bad and The Ugly Burgeoning empirical evidence suggests that credit booms may not only increase misallocation, but also sow seeds for financial crises. However, there is relative undersupply of theory accounting for these facts. To bridge the gap, we develop a unified general equilibrium banking model with heterogeneous firms to analyze the misallocation consequences of credit expansion policy both within and across sectors. The main insight is the tradeoff between credit quantity and quality. On the one hand, a moderate credit expansion has a nonmonotonic impact on the aggregate output. It raises credit potentially available for production at the cost of more severe productivity distortion. On the other hand, a sufficiently large credit expansion may trigger an interbank market crisis, generating discontinuous effect. The resulting economic recession is exacerbated by the firmlevel productivity misallocation. By extending the static model to a dynamic environment, we show that an expansionary credit policy can generate endogenous boombust business cycles despite the absence of adverse shocks.