The tax benefit of interest deductibility encourages debt financing, but regulatory constraints create dependency between bank leverage and asset risk. Using a large international sample of banks this paper shows that banks located in high-tax countries have higher leverage and lower average asset risk-weights. This trade-off is stronger when regulation is more stringent and for banks with less capital. Non-financial firms' leverage and asset risk are positively related to tax rates, as further evidence of the regulatorily induced adjustment of portfolio risk. A difference-in-difference analysis provides support for a causal interpretation of these results. Overall, higher tax rates are positively correlated with systemic risk, suggesting that the lower asset risk does not offset the risk-inducing effect of tax rates on bank leverage.

We present a model in which flat (state-independent) capital requirements are undesirable because of shocks to bank capital. There is a rationale for countercyclical capital requirements that impose lower capital demands when aggregate bank capital is low. However, such capital requirements also have a cost as they increase systemic risk taking: by insulating banks against aggregate shocks (but not bank-specific ones), they create incentives to invest in correlated activities. As a result, the economy’s sensitivity to shocks increases and systemic crises can become more likely. Capital requirements that directly incentivize banks to become less correlated dominate countercyclical policies as they reduce both systemic risk-taking and cyclicality.

In an approach analogous to Rajan and Zingales (1998), we examine how the ability to access long-term debt affects firm-level growth volatility. We find that firms in industries with stronger preference to use long-term finance relative to short-term finance experience lower growth volatility in countries with better-developed financial systems, as these firms may benefit from reduced refinancing risk. Institutions that facilitate the availability of credit information and contract enforcement mitigate refinancing risk and therefore growth volatility associated with short-term financing. Increased availability of long-term finance reduces growth volatility in crisis as well as non-crisis periods.