Universal Banking, Optimal Financing Structure, and Banking Regulations

We study how universal banking, that is, allowing banks to take equity positions in firms to which they lend, affects optimal financing structure and social welfare. Financing a firm through equity holding can improve a bank’s risk-taking incentive in restructuring the firm in bad times, but it is costly due to information asymmetry about the firm payoff in good times. We show a small increase in firm quality or bank capital ratio can cause the financing contract to switch from too much equity holding to too much debt financing, resulting in substantial welfare loss. Therefore, an equity holding restriction aiming at limiting banks’ excessive risk-taking may reduce welfare by overcorrecting the problem, and the optimal capital ratio may inevitably induce too much risk-taking.