uninnovative). The privately-optimal level of bank leverage is neither too low nor too high: It balances effi ciently the market … leverage. However, when correlated bank failures can impose significant social costs, regulators may bail out bank creditors … making bank debt too safe. The optimal capital regulation requires that a part of bank capital be unavailable to creditors …

This paper develops a structural credit risk model of a bank that issues deposits, shareholders' equity, and fixed or … floating coupon bonds in the form of contingent capital or subordinated debt. The return on the bank's assets follows a jump …-diffusion process, and default-free interest rates are stochastic. The equilibrium pricing of the bank's deposits, contingent capital …