Leverage, Competitiveness and Systemic Risk in Banking

Corporate income taxation and prudential regulation are complementary instruments for public policy in banking markets. The common deductibility of interest payments induces debt bias and causes banks to be excessively levered. A reduction in debt-bias can achieve two goals at the same time: It enhances resiliency by lowering the cost of equity and it enhances the global competitiveness of banks by strengthening their capital structure. Moreover, even reforms that are fiscally neutral in the short run will reduce the fiscal burden on bank rescue operations in the long-run.