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In this article, we consider the impact of asymmetric information between managers and investors on the optimal capital structure decision. This is done within a continuous-time framework, where the relevant state variable is given by the EBIT value of the firm; an approach taken by (2004) amongst others. Our setup differs in that we assume the EBIT to follow an Arithmetic Brownian motion, i.e. it can assume negative values. More importantly, we extend this framework in two directions: (i) We introduce a separate management claim. (ii) We introduce asymmetric information between managers and investors by assuming that claimants receive noisy signals, which they process according to rational expectation principles.Our results show, that managers always try to avoid debt, and that their optimal bankruptcy threshold is always lower, than the threshold set by equity holders. The introduction of asymmetric information changes the optimality conditions, and consequently the capital structure decision. It is shown, that the informational asymmetry can substantially lower the optimal leverage ratio, even without assuming that managers are entrenched.

We consider a regulated bank with access to bond and insured deposit financing. Bank manager-owners have specific abilities, which allows them to extract rents. We show that deposit finance acts as a commitment device that has the potential to raise the overall debt capacity of the bank and increases pledgeable assets. Our focus is on the optimal mix of bond and deposit financing. We find that in the optimum, the bank chooses a debt structure so as to align internal incentives with external constraints. The model predicts that banks with more risky assets or with more specialised human capital use deposit financing to a lesser extent.