The Value of the Bank Under Endogenous Liquidity Risk: The Modigliani-Miller Theorem Revisited

November 2017
Linda M. Schilling

The paper demonstrates that the Modigliani Miller Theorem on capital structure does in general not apply to banks when faced with endogenous liquidity risk in form of bank runs and asset illiquidity. The Modigliani Miller Theorem states that under certain assumptions, firms with different capital structure must have same values if they have identical return distributions (risk class). This paper shows, under endogenous liquidity risk that the bank's risk clalss changes in debt ratio and coupons demanded by depositors such that the Modigliani Miller Theorem can in general not apply when repricing of risk in form of higher coupons is taken into account. In equilibrium, bank value is non-monotone in capital-structure. In particular, only the all equity financed bank achieves the highest risk class.