A consequence of the financial crisis has been a lot of regulatory requirements for the financial sector. There has been a huge debate on whether stricter requirements on banks' capital is beneficial or harmful to the economy. Our theoretical analysis of the increased capital requirements on the basis of Admati et al.  are relevant to this debate. We have looked at shareholders' incentives to leverage reduction, in the hope of understanding why leverage reduction is difficult, from the shareholders' point of view and whether it matters how banks reduce leverage. We have also tried to see if it has any positive effect if the requirements are phased in gradually. The analysis has shown that a bank won't recapitalize even if it increases the overall value of the bank. Recapitalization allocates more value to the bond holders as debt becomes more secure. It is therefore too expensive for shareholders to purchase the debt at the market price. If the bank has the opportunity to buy back junior debt it will be less costly for the shareholders but they will still loose. Besides recapitalization the bank can sell or expand assets to reduce leverage. With one type of debt and the assets priced such that net present value of asset sale/expansion is zero, the three methods are equivalent. With the more realistic asset price set to 1 buying new assets will be most favorable for the bank as long as having debt gives the bank a positive trade off. A conclusion that contradicts the idea that increased capital requirements will cause banks to cut on their lending activities. On the other hand if the assumption of one type of debt is relaxed and the bank can buy junior debt, asset sale can be the most favorable method for the bank. If the capital requirements are phased in gradually the bank has a better basis for the decision of whether it should pay dividends or not. They can choose to keep the retained earnings and use them later to reduce leverage. If the requirements more or less come as a chock the bank has already paid (some of) the retained earnings as dividends. This means that the assets are reduced and a leverage reduction will be more costly since the bank's leverage are farther from the required leverage than before the dividend payment.
|Educations||MSc in Mathematics , (Graduate Programme) Final Thesis|
|Number of pages||78|