[email protected] Economics Working Papers

Department of Economics

February 2009

Bank Capital Requirements and Capital Structure John P. Harding University of Connecticut

Xiaozhong Liang State Street Corporation

Stephen L. Ross University of Connecticut

Follow this and additional works at: http://digitalcommons.uconn.edu/econ_wpapers Recommended Citation Harding, John P.; Liang, Xiaozhong; and Ross, Stephen L., "Bank Capital Requirements and Capital Structure" (2009). Economics Working Papers. 200909. http://digitalcommons.uconn.edu/econ_wpapers/200909

Department of Economics Working Paper Series Bank Capital Requirements and Capital Structure John P. Harding University of Connecticut

Xiaozhong Liang State Street Corporation

Stephen L. Ross University of Connecticut

Working Paper 2009-09 February 2009

341 Mansfield Road, Unit 1063 Storrs, CT 06269–1063 Phone: (860) 486–3022 Fax: (860) 486–4463 http://www.econ.uconn.edu/ This working paper is indexed on RePEc, http://repec.org/

Abstract This paper studies the impact of capital requirements, deposit insurance and tax benefits on a bank’s capital structure. We find that properly regulated banks voluntarily choose to maintain capital in excess of the minimum required. Central to this decision is both tax advantaged debt (a source of firm franchise value) and the ability of regulators to place banks in receivership stripping equity holders of firm value. These features of our model help explain both the capital structure of the large mortgage Government Sponsored Enterprises and the recent increase in risk taking through leverage by financial institutions. Journal of Economic Literature Classification: G21, G28, G32, G38, M48 Keywords: Banks, Capital Structure, Capital Regulation, Financial Intermediation, Leverage, GSE, Investment Banks

1. Introduction The current financial crisis illustrates that highly leveraged capital structures are a significant source of risk for financial institutions and for society as a whole.1 Banks, as financial intermediaries, are different than other firms. Significantly, banks have the unique benefit of being able to issue federally insured debt; but they also bear the cost of capital regulations, including the threat of being placed in receivership and wiping out the investment of the shareholders. Banks also manage financial, rather than physical, assets implying lower bankruptcy costs than industrial firms. This paper examines how these special characteristics influence the optimal capital structure of banks. Earlier studies of bank capital structure have generated conflicting predictions. First, traditional moral hazard theory has been applied to predict that banks with deposit insurance will choose extremely high levels of leverage (Keeley 1980, Marshall and Prescott 2000, Gueyie and Lai 2003)2 because the insurance premium does not reflect or adapt to the underlying risk of the insured’s activities.3 Meanwhile, casual observation of banks’ choices of capital structure indicates that banks do not operate with capital ratios equal to the regulated minimum. The insurance premium paid by banks for deposit insurance is only one component of the total regulatory cost associated with deposit insurance and other studies that consider these regulatory costs generally predict that banks will not choose high leverage. Buser, Chen and Kane (1981) point out that banks face significant costs that are not explicitly priced attributable to regulations, investment restrictions and monitoring. Merton (1978) develops a contingent claims model of 1

Since the seminal work of Modigliani and Miller (1958), many papers including Jensen and Meckling (1976), Myers and Majiluf (1984), Myers (1984), and Fama and French (2002) have examined the capital decisions of forward looking firms using models that balance the benefits and costs of additional debt. 2 Another explanation for banks choosing high leverage is offered by Diamond and Rajan (2000) and Diamond (2001) who consider the optimal capital structure of banks as the result of the tradeoff between liquidity creation, costs of bank distress, and the ability to force borrower repayment. 3 Insured deposits represent one of the lowest cost capital sources for banks and, in recent years, most solvent banks have paid almost no premium for their insurance.

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bank leverage that includes explicit regulatory costs for insolvent banks. He shows that this regulatory burden can be significant enough to create a preference for equity among solvent banks. Based on Merton’s model, Marcus (1984) explicitly examines bank capital structure under capital regulation and argues that “for solvent banks, increases in capital are wealthincreasing, while for sufficiently insolvent banks, capital withdrawals increase owner’s wealth.” These results are unsatisfying in the sense that for solvent banks (and most operating banks are solvent), these models suggest the opposite corner solution (all equity financing) than did the moral hazard models, and both corner solutions are clearly inconsistent with actual bank capital choices. The purpose of the Merton and Marcus papers was to demonstrate the importance of the regulatory burden associated with deposit insurance for bank capital decisions. The Merton and Marcus models, however, exclude consideration of a significant benefit—the value of possible future insurance payments. Accordingly, while the models above demonstrate the importance of either moral hazard or capital regulation, they do not support policy-motivated analyses because their predictions are at odds with empirical regularities. In the one exception to this pattern, Elizdale and Repullo (2007) develop a model of bank capital structure where banks enjoy a franchise value associated with borrowing at the risk free rate, but if the bank experiences a loss, the owners must infuse additional capital sufficient to reset its capital to the optimal start of period ratio, or if the loss is severe enough, the bank is closed by the regulator or owners.4 However, Elizdale and Repullo’s (2007) model allows banks to freely recapitalize every period undoing the additional risk of dissolution created by a series of negative shocks. Under their model, banks are not required to plan ahead for the risk associated with the possibility of multiple periods of negative shocks that slowly erode a bank’s capital 4

The bank’s profitability each period is stochastic representing the loss from bad loans, and the authors numerically solve the resulting Bellman equation for various parameterizations of the problem. The authors also derive a limited number of comparative static results.

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position. The recent financial crisis emphasizes the importance of considering models that do not allow for the recapitalization of financial firms in response to negative shocks. Our paper builds upon the general model of firm capital structure developed by Leland (1994) to provide a comprehensive framework of bank capital structure decisions under a deposit insurance system. Leland derives a closed-form expression for the optimal capital structure of a firm that issues risky debt in the presence of bankruptcy costs and tax-advantaged debt. In our model, we consider a scenario where the bank can borrow or take deposits at the risk free rate because those deposits are insured by the government, but the bank faces an insolvency threshold that is established by a regulator where capital regulations require the liquidation of the bank when the capital ratio falls below the threshold.5,6 Like Elizdale and Repullo (2007), our model also reflects a balancing of benefits and costs that result in an interior solution, but banks in our model, as in Leland’s, face a one-time decision concerning capital structure. While this may initially sound unduly restrictive, there are significant frictions that prevent continuous capital rebalancing and most banks are not able to return to the market period after period to recapitalize the bank in response to losses - especially during economic downturns. Our model reasonably represents a world where banks when determining capital structure must plan for adverse economic environments in which capital cannot be easily raised.7 We find that there exists an interior optimal capital ratio in banks with deposit insurance, a minimum capital ratio and tax-advantaged debt. That is, banks voluntarily choose to hold

5

This case is similar in spirit to both the regulatory burden considered by Elizdale and Repullo (2007) and Leland’s model of protected debt. 6 We extend this model to analyze two capital thresholds: a high “warning” level and a lower insolvency level where the bank is liquidated. We find that the additional warning threshold has only a small impact on the optimal level of leverage, even with substantial warning costs. This finding further emphasizes the importance of the threat of forced liquidation when considering the effectiveness of capital regulation; see Harding, Liang, and Ross (2007). 7 Unlike Elizdale and Repullo (2007), we find that a bank may choose all equity, i.e. zero debt or deposits in models without tax advantaged debt. This difference does not arise from a fundamental difference between the models, but rather because in our model the regulator liquidation threshold is a policy parameter that can be selected.

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capital in excess of the required minimum. This does not mean that minimum capital requirements are ineffective. Rigid capital requirements threaten all banks with the prospect of losing the value of their equity if the bank violates the requirement as the result of random fluctuations in asset values. Accordingly, banks choose capital ratios well above the minimum requirement to maximize the expected value of their equity. If there were no capital requirements, banks would choose a corner solution with very high leverage. Hence the real function of capital requirements is to create a cost of insolvency that replaces bankruptcy costs in the establishment of an optimal firm capital structure. Tax-advantaged debt is central to the existence of an interior optimal capital ratio. Bankruptcy costs and insurance benefits are small relative to tax benefits and move together with changes in deposits while tax benefits create a large franchise value that is put at risk by capital regulation. This finding is comparable to results of Marcus (1984)8 and Hellman, Murdock, and Stiglitz (2000)9 who document an important role for Charter or franchise value in understanding the impact of capital standards on bank risk taking behavior. The remainder of this paper is organized as follows. Section 2 develops a model of the capital structure of banks, and section 3 analyzes the bank’s optimal capital structure. Section 4 considers the implications of this model for regulatory policy, and the last section summarizes the main conclusions. 2. Bank Capital Structure with Deposit Insurance and Capital Regulation In developing our model of the capital structure of banks, we follow the derivation of Leland (1994). In Leland’s framework, a firm’s assets are financed with a combination of debt 8

Marcus extends his model to consider the value of a bank’s charter finding that this extension reinforces his prediction that solvent banks should choose low leverage. Hughes, Lang, Moon and Pagano (2003) find empirical evidence in support of Marcus’s proposition about the importance of charter value. 9 Hellman, Murdock, and Stiglitz focus on the risk arising from the investment portfolio choice of banks. Also see Caprio and Summers (1996) on the importance of franchise value.

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and equity. Uncertainty enters the model because the firm’s assets are assumed to evolve stochastically. To assure that the stochastic process for the assets is unaffected by the capital structure choices of the firm, debt service payments are made by selling additional equity.10 This implies that the face value of deposits is static over time. In applying this framework to banks, we assume that banks have only one form of debt — fully insured deposits and that these deposits are deemed by investors to be riskless. Consistent with recent experience in the U.S., we further assume that banks do not pay an insurance premium for deposit insurance.11 Under these assumptions, banks pay the riskless rate on all deposits. As in Leland, we assume that values evolve continuously and that the firm’s capital structure decision is summarized by its choice of a promised continuous payment C.12 We assume that the firm’s portfolio of assets, V, comprises continuously traded financial securities13, the market value of which follows a standard geometric Brownian motion process: dV = µVdt + σVdW

(1)

Following Cox, Ingersoll and Ross (1985) and assuming a fixed riskless rate r, a claim, F(V,t), with a continuous payment, C, must satisfy the standard partial differential equation (with boundary conditions determined by payments at maturity and/or time of insolvency): 1 2 2 σ V FVV + rVFV + Ft − rF + C = 0 2

(2)

10

Although this assumption allows firms to raise some capital during an economic downturn, the firms are not able to recapitalize after negative shocks and so face increased likelihood of involuntary closure by regulators. 11 Incorporating an insurance premium calculated as a fixed percentage of the face value of the insured deposits is straightforward and does not materially change the results discussed here. 12 Consider an investor who is forming a bank. We assume that the firm’s initial book of assets, V, is fixed and the bank owner must choose how to best finance those assets—with either debt or equity. In our framework, the bank assets are fixed and the owner must first choose the optimal amount of deposits to issue to the public. The bank’s owner must then contribute the remaining funds needed to purchase the initial assets. We assume that, as a practical matter, local market conditions and federal regulations impose upper bounds on firm size. 13 A bank’s assets comprise two major categories: loans and securities. While the assumption of active trading is valid for the securities component, we assume that the loan component is perfectly correlated with some actively traded benchmark security. We believe this assumption is reasonable given the close linkage between loan rates and capital market rates.

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While, in general, this partial differential equation does not have a closed form solution for arbitrary boundary conditions, if Ft=0, then equation (2) becomes an ordinary differential equation with the general solution: F (V ) = A0 + A1V + A2V − X

(3)

where X=2r/σ2 and A0, A1 and A2 are determined by the boundary conditions. In the context of corporate debt (Leland, 1994), the assumption Ft=0 can be justified by considering only long maturity debt or debt that is continuously rolled over at a fixed rate or a fixed spread to a benchmark rate.14 The latter justification is also applicable to banks. Ever though most bank deposits technically have short maturities, as long as the bank is solvent and maintains competitive pricing, it can rollover deposits at the riskless rate because depositors do not have an incentive to monitor a bank’s financial condition. For example, although demand deposits can be withdrawn at any time by the customer, in bank acquisitions, these deposits are generally viewed as a long-term, stable source of funds and hence part of the charter value of the bank. Using the general solution in equation (3), we can obtain an expression for the major claims that influence the market value of a firm including the current market value of potential bankruptcy costs (BC), of tax benefits associated with debt financing (TB), and of a new claim not considered by Leland the insurance provided by the federal government (IB). These costs can be viewed as a contingent claim on V, and we define the market value of the bank, v, as v = V − BC (V ) + TB (V ) + IB (V )

(4)

2.1. Bankruptcy Costs To apply equation (3) to value bankruptcy costs, we need to identify the appropriate boundary conditions that reflect the actual payments associated with the claim. When a bank

14

See Leland (1994) for a detailed explanation, and Leland and Toft (1996) for a model with finite maturity debt.

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becomes insolvent, its assets are liquidated. The liquidation is triggered when the value of the firm’s assets, V(t), falls to a specified level, VB. For our current purpose, it does not matter how VB is set—only that it is an observable constant. We assume that when liquidation occurs, the firm will receive a fraction of the current market value of the assets, (1-α)VB, where 0βD, where the parameter β measures the stringency of the capital requirement. We assume a single capital threshold19 and further assume that the bank is liquidated if it does not meet the specified requirement—i.e., when V first falls to βD or β(C/r). Therefore, once the bank chooses D, βD can be viewed as the insolvency threshold.20 This regulatory environment can be expressed in the more traditional language of minimum capital requirements and maximum leverage using the basic accounting identity that V=D+Eq, where Eq denotes the book value of equity not the market value of equity, E(V). A requirement to maintain a minimum capital ratio can be thought of as requiring (Eq/V) to remain above the specified threshold c. Using the accounting identity, this establishes a maximum leverage ratio, D/VD/1-c. Thus, β=1/1-c. Thus, if we set VB= βrC and substitute into equation (9), we have:

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This simplified regulation structure is equivalent to considering a bank that only has Tier I capital and a low risk portfolio for which the book assets capital ratio is the binding constraint. 19 As mentioned earlier, we also extend this model to analyze the case with two regulator thresholds. The higher warning threshold results in increased monitoring and scrutiny that imposes additional costs on the bank, but the bank continues to hold a claim on the value of bank equity. See Harding, Liang, and Ross (2007). 20 Note that β=1 is equivalent to Leland’s (1994) case of protected debt. For the regulatory constraint on capital to have any effect, β>

X 1+ X

, where X=

2r

σ2

. If β were set below this level, it would have no effect on the bank because it

would be below the insolvency threshold the bank would select in the absence of capital regulation. See Harding, Liang, and Ross (2007) for a derivation of the optimal bankruptcy threshold for banks.

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C X C v (V ) = V + IB (V ) − BC (V ) + TB (V ) = V + τ − k , where V r k = (τ + β - 1)

β r

(11)

X

Depending on the magnitudes of τ and β, k can be positive, negative or zero. In practice, however, we expect (τ + β)>121 and thus we expect that k>0. In fact, as will be seen later in equation (13), an interior optimal value of C does not exist if k≤0. With k>0, the sign of the second term in equation (11) is indeterminate and the market value of the firm can be greater than or less than the value of its assets, V, depending on the magnitudes of C and β.

3. Optimal Capital Structure of Banks 3.1. Determining the Firm’s optimal Choice of Leverage As in Leland (1994), we consider a value maximizing bank.22 First, consider a world without tax advantaged debt where τ is set to zero in equation (11). The bank’s optimal choice of C and hence leverage depends in a “knife-edge” way on k and therefore on the capital regulation standard β because with τ=0, k=β-1. When β>1, the market value of the bank, v(V) is a monotonic decreasing function of the coupon payment, C,23 and the bank is liquidated before V falls below the market value of deposits and thus while the shareholders still have positive 21

For example, τ should be on the order of 0.2 to 0.4 and β should be close to one if not greater than one to avoid an insurance payout in excess of bankruptcy costs in the event of insolvency. 22 In our model, firm value and equity value differ by the term -C/r. Thus for a fixed r, there is no difference between choosing the coupon payment that sets the partial derivative of the firm value equal to zero, and choosing the coupon that sets the derivative of equity equal to -1/r. Since firm value is fixed and the coupon determines the value of debt, this condition maximizes the current value of equity. Specifically, adding a dollar to the coupon increases initial debt and decreases initial equity investment by -1/r, and so a change in the value of equity of -1/r is consistent with no change in the value of existing equity. 23

Note that

∂v p −X X = − V (1 + X ) C < 0 , for c > 0. ∂C r

This effect can also be seen in equation (11) with VB>C/r. The

second term on the right hand side of the equation is negative, implying an expected loss from liquidation, net of the insurance benefits

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equity. This equity is wiped out by the liquidation. The “cost” to the equity holders from this expected loss exceeds the market value of the small insurance payout when β>1.24 When β1-τ.

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top of the figure. The high concave (solid) line represents the market value of the tax benefits, the convex (dash-dotted) line represents the bankruptcy costs, and the dashed line represents the insurance benefits. All three values are plotted against the coupon payment C. The figure shows that tax benefits increase sharply with C when the resulting leverage are low. However, at higher levels of leverage, the tax benefits begin to decline as the result of the increased likelihood of insolvency. Tax benefits are zero when VB=V (or C=rV/β). The figure also points out the critical role that the tax benefits play in determining the optimal leverage because they are relatively much larger than either of the other claims over much of the relevant range for C. With β set conservatively at 1.05, the bankruptcy costs increase with C more rapidly than do the insurance benefits, but the net insurance benefit is small over the entire range of C. Consistent with an interior optimum value of l * , banks voluntarily choose a level of deposits that is significantly less than the maximum permitted under the capital regulation. Without strict capital regulation and the resulting threat of early liquidation and the loss of franchise value, banks with insurance benefits would seek to take on as much leverage as possible. The combination of a capital requirement and the threat of liquidation with the potential for significant loss creates an incentive for banks to limit their use of deposits.

3.2. Factors that Influence Optimal Capital Structure C* as a function of r. The optimal coupon C* is monotonically increasing in g, and g is an increasing function of the riskless rate r (a decreasing function σ and β), as long as β>1-τ.29 A decrease in r (increase in σ and β) leads to a higher likelihood of insolvency, ceteris paribus, and so lead the bank to select a lower coupon rate.

29

The results for the riskless rate and volatility of assets also require the assumption that log(1+X)>1/X where X=2r/σ2. This assumption is satisfied whenever 2r/σ2>1, which is a fairly standard assumption in financial models.

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The parameter g can also be thought of as an optimal “asset payout rate” to debt holders from the bank’s financial assets V, and as noted in footnote 27 the asset payout ratio g is also equal to r l*. Figure 2 plots g/r or l* as a function of the riskless rate r, using the same parameter assumptions as figure 1. The figure shows that the bank’s optimal initial leverage increases monotonically with r, ranging from slightly below .5, when the riskless rate is very low, to approximately .75 for a riskless rate of ten percent. Increases in r, ceteris paribus, lead to a lower likelihood of insolvency and as a result, the firm chooses higher leverage.

C* as a function of τ. Next, we investigate the relationship between the bank’s capital structure decision and the corporate tax rate. Taking the partial derivative of the optimal coupon (equation 13) with respect to the tax rate, we obtain:

∂C * ∂τ

=

gV β − 1 Xτ τ + β − 1

(15)

We first observe that for values of β close to one, the sensitivity of C* to changes in the tax rate is small. Nevertheless, it is instructive to consider how the tax rate interacts with the nature of the capital requirement, β to influence C*. The sign of the partial derivative in equation (15) depends on the sign of the term in brackets. For stringent capital requirements when β>1, this term is positive and the optimal debt service payment, C*, is increasing in the tax rate. However, if β1, the bank would prefer to not use any debt in order to avoid the risk of insolvency costs. The use of debt is motivated entirely by the desire to capture the tax benefits of debt. In that environment, larger tax benefits associated with a higher tax rate provide more incentive to use debt. When

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β1, g exists and L*>0. However, for the optimal capital structure to be consistent with leverage less than one, the denominator must be greater than one. This condition is met as long as g1), the first term of the denominator will be greater than one. The second term adds a fraction of the tax rate and thus the optimal leverage will be between zero and one.31

30

It should be noted, however, that, ceteris paribus, a bank with β1. The difference we are talking about here is in the response of the bank to a change in tax rate. The first bank would lower its very high leverage while the second would increase its lower leverage. 31 Under the risk neutral probability measure, all assets have a drift equal to the riskless rate. If banks chose to commit to a debt service payment rate (as a percentage of its assets) that is in excess of the asset drift, this would imply market value of debt in excess of the market value of assets under the risk neutral measure and the bank would be unable to raise new equity to service the debt commitment. Not surprisingly, simulations indicate that the

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Unlike the bank’s choice of C*, L* is inversely related to the tax rate, regardless of the stringency of the capital threshold. The first order partial derivative of L* with respect to the tax rate is: 2 ∂L* r β −1 X + = − L* − ∂τ Xgτ τ + β − 1 1 + X

( )

(17)

The partial of L* with respect to the tax rate is negative because the second term in brackets is unambiguously positive and for reasonable parameter values larger than any negative values taken by the first term.32 While the finding that leverage decreases with the tax rate is intuitive for the case (β1 and the bank optimally increases C* as a result of an increase in the tax rate. The result arises because although an increase in C* directly increases D*, it also increases v*(V) because of the inclusion of the contingent claim in v(V). In fact, v*(V) increases more rapidly than D* as a function of the tax rate, with the result that L* actually declines. These results suggest that a change to lower corporate tax rates may have the unintended consequence of increasing the optimal leverage ratio for banks.

3.3. Numerical Example In this section, we demonstrate certain policy implications of our model through numerical examples. In all cases, we assume the initial value of the bank’s financial assets, V(0), is one hundred dollars. For our base case, we set β=1 because at that value bankruptcy costs and insurance benefits perfectly offset each other. We further assume that the risk free rate r=0.06, volatility of asset returns σ=0.15, and the effective corporate tax rate τ=0.25. Although, the bankruptcy cost parameter, α, does not enter the formulas for firm value directly, it does optimal coupon payment implies leverage between 0 and 1 for most values of β between (1-τ) and 1. Leverages above 1 can arise for values of β near (1-τ), but at such values g is near zero where an optimal coupon does not exist. 32 As in the previous footnote, in practice, this relationship only breaks down for values of β near (1-τ).

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influence the maximum level of β that the regulator can choose since we have assumed throughout that β $1 billion) is 32.7%.

19

its measure of firm size, the market value of leverage (L1) understates the “book” value calculation of leverage (L2). The last two columns in Table I present the value and capital structure of a comparable, unregulated, firm as studied by Leland (1994) using bankruptcy costs based on α=0.10. The first column of the pair presents the results for an unregulated firm that is free to choose its own bankruptcy threshold endogenously. The last column presents the results for a firm with protected debt that results in a positive net worth requirement (β=1). The first firm type (with unprotected debt) chooses a higher coupon than all the banks with the exception of the least constrained bank with low tax rates. It chooses a very low bankruptcy threshold which contributes to the very high tax benefit reported for these firms. This enhanced tax benefit outweighs the fact that the unregulated firm has no insurance benefit and the overall firm value is higher than all but the least regulated bank.34 However, if the firm must provide debtholders with a positive net worth covenant, the firm voluntarily chooses a lower level of debt service. In turn this lowers the tax benefit and the value of the firm. The firm that issues protected debt has a lower optimal firm value than all but the bank with the highest capital requirement. These results suggest a positive charter value for operating an insured bank—even in the face of significant capital regulation. Table II presents a similar set of panels varying the level of asset price volatility, σ, from 10% to 25% while holding the tax rate fixed at 25%. In general, the optimal debt service payment, C*, declines as volatility increases. For β=1, C* falls by 29.3 percent as σ rises from 10 34

The possibility that a regulated bank might choose a leverage level that is higher than an unregulated firm without protected debt deserves some discussion. For the regulated bank that operates under the weakest capital standards, the insurance benefits net of bankruptcy costs provide an incentive for taking on more debt. It is only the risk of losing tax benefits due to forced liquidation that yields an interior optimal capital ratio. As tax rates decrease, this risk becomes less important and bank leverage increases, while for the unregulated firm tax benefits create an unambiguous incentive for taking on more leverage.

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to 25%. Holding other factors equal, as volatility increases, the expected first passage time for V(t) to strike VB decreases thereby increasing the value of contingent claims payable at insolvency. The primary factor behind the decline in C* is the increased risk of forced liquidation by regulators and the associated loss of tax benefits, which as discussed previously is the largest contingent claim. For all values of β considered, tax benefits fall by approximately 50 percent as volatility rises from 10 to 25%. The effect of insurance benefits net of bankruptcy costs on C* depends upon β. For lax regulatory environments, where β1, the insurance benefits are smaller than bankruptcy costs, and the magnitude of this negative net benefit increases with volatility leading to lower leverage. In terms of magnitude changes as volatility rises from 10 to 25%, insurance benefits net of bankruptcy costs increases by 3.54 when β=0.9 and decreases by 0.67 when evaluated at C*. These factors have clear implications for the market value of the firm. As volatility increases, the risk of loss of future tax benefits because of insolvency dominates any increases in the value of the firm due to insurance benefits even when capital regulation is lax, β