We develop a general equilibrium model of banks' capital structure, featuring heterogeneous portfolio risk and an imperfectly elastic supply of bank equity stemming from financial market segmentation. In our model, equity is costly and serves as a buffer against insolvency. Banks are ex-ante identical, but may need to recapitalize by selling equity claims after their portfolio risk becomes public knowledge. When the need to issue outside equity arises simultaneously in a large number of banks, the market for equity becomes crowded. Reminiscent of asset fire sales, banks do not fully internalize the effect of their individual equity issuance on the endogenous cost of equity and their future ability to recapitalize. As a result, they are inefficiently under-capitalized in equilibrium, and the incidence of insolvency is inefficiently high. This constrained inefficiency provides a new rationale for macroprudential capital regulation that arises despite the absence of deposit insurance, moral hazard, and asymmetric information; it also has implications for the regulation of payout policies and the design of bank stress testing.
Macroprudential policy capital regulation capital structure financial market segmentation incomplete markets constrained inefficiency