Theoretical Literature

Abstract

If financial markets are assumed to be complete and depositors are perfectly informed about the failure risk of banks, the Modigliani and Miller (1958) indeterminacy principle applies. This, however, requires that owners do not have the possibility to exploit depositors. To illustrate this problem, let us assume that bank managers act in the interest of owners, who seek to maximize the value of equity. If the bank is a corporation (as most banks are), the bank owners’ liabilities are limited to the amount of their investments. This means that the owners’ losses are limited, but their gains are not: Once, the value of the bank is greater than the fixed amount owed to depositors, gains fully fall to owners. Due to this convex payoff function of owners, banks prefer risky to save investments.