How do asset encumbrance and debt regulations affect bank capital and bond risk?

We study how optimal bank capital and bond risk are influenced by asset encumbrance, depositor preference, and bail-in resolution frameworks. Due to changes in optimal capital structure, the net effect on bond debt risk and valuation is small. The effects on shareholder value and public sector liability value are significant. A gap between optimal and required capital represents a cost to shareholders and increases the risk of regulatory arbitrage. The features of bank debt financing we analyze here may explain the stable cross-sectional variation in bank capital documented in literature. Based on a small sample of European banks, we find support for the central model predictions.