Banks strategically choose and dynamically restructure deposits and non-deposit debt in response to the minimum requirements on total capital and tangible equity. We derive the optimal strategic liability structure and show that it minimizes the protection for deposits, conditional on capital requirements. Although given any liability structure, regulators can set capital requirements high enough to mitigate the incentive for risk substitution, the strategic response to the capital requirements always preserves this incentive. Banks reduce leverage but increase the proportion of non-deposit debt if regulations raise the capital requirements.
Management Science. Forthcoming.