Banks, Taxes, and Nonbank Competition

This paper models banks’ choice of capital structure and interest rates on loans and deposits when financial services markets are characterized by economies of scope, corporate taxes, and competition from nonbanks (shadow banks). In markets with rich retail lending opportunities but limited retail savings, banks may choose high equity capital (low leverage) when they are not subject to corporate income taxes. When banks are taxed, equity capital declines and retail borrowers bear the tax burden. For the opposite case of markets with few lending opportunities but plentiful retail savings, banks minimize capital and the tax burden falls on depositors. When banks face greater nonbank competition for retail savings, equilibrium loan rates increase, encouraging entry from nonbank lenders. The model’s predictions are consistent with U.S. banks over the last two centuries. Recent empirical research on how taxes affect bank behavior also supports the model.