Abstract - DIVIDING RENTS BETWEEN LABOR AND CAPITAL: AN INTEGRATED THEORY OF CAPITAL STRUCTURE FOR FINANCIAL AND NON-FINANCIAL FIRMS

Why do commercial and investment banks have so much more leverage than the average non-financial firm, and why do information-technology firms have so much less leverage? Thus far, these questions have been addressed separately, resulting in one set of capital structure theories for non-financial firms and another for financial firms, thereby creating a wall between the rich sets of insights developed in these two groups of theories. In order to develop an integrated theory of capital structure for financial and non-financial firms, this paper alters the Modigliani and Miller (1958) model in two respects (i) it allows the firm's manager to make an inefficient project choice that can be noisily detected by financiers via an information signal with endogenously-chosen precision, and (ii) it gives labor a role to play in providing effort that affects the value of the firm's illiquid and intangible assets. There is a rent-extraction tension between the providers of capital and the providers of labor inputs, with each vying to maximize its rent extraction in a world with incomplete contracting. The firm's financiers use capital structure to overcome
the incompleteness of explicit contracts and strike the value-maximizing balance between the need to minimize rent extraction by labor and the need to provide labor with enough rents to elicit the desired effort. The model predicts that liquidity creates leverage ? firms with a greater portion of value accounted for by liquid assets choose higher leverage ? thereby reversing the currently-accepted causality. Moreover, among firms with the same book value of assets, more highly levered firms will have lower market-to-book ratios for total firm value. This explains why financial firms ? with the predominant fraction of their assets represented by liquid assets ? are more highly levered than other
firms and also tend to have relatively low market-to-book ratios, and why technology firms that create intangible assets that are mostly illiquid have low leverage. Numerous additional predictions are derived, including those that reflect asset liquidity and the marginal productivity of labor.

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