Risk, Leverage, and Regulation of Financial Intermediaries

This paper presents a model on the leverage of financial intermediaries, where debt are held by risk averse agents and equity by the risk neutral. The paper shows that in an unregulated competitive market, financial intermediaries choose to be leveraged over the social best level. This is because the leverage of one intermediary imposes a negative externality upon others by reducing their profit margins. The paper thus founds capital adequacy regulation upon the market failure and suggests that this regulation should bind not only commercial banks, but all financial intermediaries, including private equities and hedge funds.