ABSTRACT The theory of corporate finance is not directly applicable to financial intermediary decision‐making. The lack of applicability stems largely from the particular conditions that distinguish intermediary operations from those of the nonfinancial firm. First, when intermediaries accept deposit financing, they must produce services such as liquidity and convenience at considerable expense for real resources. Second, the introduction of intermediation is likely to be accompanied by incomplete markets so that shareholder unanimity is not in general valid. In this paper, a model with incomplete markets is developed and a shareholder approved rule for intermediary capital structure decisions is derived.

This paper presents a model of incentive compatible bank regulation under moral hazard and adverse selection. We derive a wide range of simple and conceptually implementable mechanisms that can solve each type of incentive problem separately and also achieve the first-best outcome – but only when regulatory instruments involve ex post pricing that is contingent on the bank's performance relative to the market. An important feature of these mechanisms is that they do not involve a subsidy to the bank. When the regulator faces both moral hazard and adverse selection simultaneously, we identify the conditions under which the same mechanism can achieve the first-best solution.