Illiquidity Risk and Capital Structure of Financial Institutions

Abstract

Following the framework for credit risk developed in Morris and Shin (2016), I construct a model for the financial structure decision of a bank in light of illiquidity and insolvency risk. Numeric analysis shows that the tax benefit of short-term debt can be outweighed by the negative effects of illiquidity risk for certain values of exogenous parameters, leading to a breakdown of the pecking order theory of financial structure. I qualitatively discuss an extension to a sequential signaling game framework similar to that of Noe (1988), as well as the policy implication that recent regulatory requirements concerning liquidity are sensible but imperfect.