COSTLY VERIFICATION AND BANKING

This paper outlines a model in which costly state verification leads t o the emergence of a bank-like financial intermediary that issues both debt and equity liabilities. Shareholders incur verification costs wh en projects in the bank's asset portfolio fail, and depositors incur v erification costs when the bank fails. The bank's optimal capital stru cture is determined by trading off shareholders' expected verification costs against depositors', and a closed-form solution is derived for the bank's optimal capital level. The comparative statics results are derived, and the implications set out for capital adequacy, shareholde r liability and bank regulation.