Deposits and Bank Capital Structure

In a model with bankruptcy costs and segmented deposit and equity markets, we endogenize the choice of the bank and firm capital structure and the cost of equity and deposit finance. Despite risk neutrality, equity capital is more costly than deposits. When they make risky loans to firms, banks trade off the high cost of equity with the diversification benefits from a lower bankruptcy probability. When bankruptcy costs are high, banks use no capital and only lend to one sector. When these are low, banks hold capital and diversify.