The response of banks’ capital structure to changes in the relative tax advantage of debt

Financial intermediaries, compared to non-financial companies, are characterized by a highly levered capital structure, raising concerns about their stability within periods of economic turbulence. Therefore, regulatory authorities recently encourage the reinforcement of equity and, hence, seek to prevent distress and failure. An important but often overlooked determinant of the capital structure is the tax deductibility of debt. This project analyzes if a reduction in the tax advantage of debt might serve as an instrument to significantly increase the equity portion in the banking industry and, thereby, contribute to a sounder financial system. Assumed that the reduction of the tax advantage of debt changes the capital structure, the project proceeds to investigate the impact of this change related to the profitability and competitiveness in the banking industry.