Costly verification and banking

This paper outlines a model in which costly state verification leads to the emergence of a bank-like financial intermediary that issues both debt and equity liabilities. Shareholders incur verification costs when projects in the bank's asset portfolio fail, and depositors incur verification costs when the bank fails. The bank's optimal capital structure is determined by trading off shareholders' expected verification costs against depositors', and a closed-form solution is derived for the bank's optimal capital level. The comparative statics results are derived, and the implications set out for capital adequacy, shareholder liability and bank regulation.