Seeking Optimal Bank Capital: Modigliani and Miller, Where Art Thou?
Many consider the regulatory push for greater capitalization justified with the view that for too long the banking sector’s levels of leverage have been too high. Nevertheless, a vexing issue amongst several banking industry stakeholders remains the question of optimal capital structure for the bank sector, with some expressing the view that more equity is expensive and has adverse economic consequences. The underlying debate of this issue is reflected in a recent Financial Times James Mackintosh article on bank capital needs. The article highlights ongoing banker murmurs against the push for greater capitalization and observes that such protests are probably unfounded and do not stack up to conventional financial theory. Besides, there is still some way to go before banks are adequately capitalised, according to a Federal Deposit Insurance Corporation (FDIC) chart related to global systemically important financial institutions. These banks have very low tangible equity levels (i.e., an average of 3.66% for eight U.S banks and 3.48% for 16 non-U.S. banks).
Equity Is Not Expensive
The common refrain by the banks against the push for higher capital levels is that their lending activities are being curtailed due to the increased cost of overall capital, driven by an increase in equity capital in particular. This is expected to result in a pass-through of the incremental funding costs to potential borrowers through higher interest rate charges. In turn, lending volumes are projected to shrink because lending products are assumed to have price elasticity. This viewpoint flies against conventional financial theory as espoused by the famous and seminal Modigliani–Miller theorem. Optimal capital structure should by definition arrive at the mix of debt and equity funding, which yields the least weighted average cost of capital. Modigliani and Miller contend that the financing mix should not impact the value created by operational and investment choices. Therefore, an increase in equity per se should not impact the cost of lending to bank customers and the profitability of lending operations.
The reference to the Modigliani–Miller theorem is not meant to suggest that this classical theory ought to supplant the existing regulatory approaches that are applied as a yardstick for determining optimal capital for banks. Existing prudential regulatory approaches (e.g. Basel) are based on refined risk-adjusted formulas and these prudential approaches more appropriately cater for the sophistication and risk of the bank business model than would the classical finance theory. Besides, the Modigliani–Miller theorem cannot readily define specific or precise optimal capital levels for the banking sector, or any other sector for that matter. The fundamental intuition contained within the Modigliani–Miller theorem is also applicable to banks and is supportive of the drive by regulators to have higher levels of equity capital.
Intuitively, the Modigliani–Miller theorem stating that the mix of debt versus equity should not matter from an enterprise-value-creation perspective also makes sense because both debt and equity funding markets should be informationally efficient. It seems misleading to assume perpetually low debt funding costs regardless of overall levels of leverage, or to assume that overall bank risk premium can only be reflected in the equity portion of funding. When banks have greater equity funding, they are safer and are bound to have a lower equity risk premium. This latter point is powerfully made in a working paper by several academics including prominent Stanford University researcher Anat Admati.
The Financial Times article highlights the disconnect that exists between the cost of equity estimate from a theoretical Capital Asset Pricing Model (CAPM) perspective versus the self-disclosed estimate for two U.K. banks.
|Bank||CAPM-based cost of Equity||Bank-declared cost of equity|
Several bank sector-based commentators make it appear as though the expectation of lower cost of equity for better capitalized banks is all theoretical malarkey, according to the Financial Times article. Nevertheless, for this debate the regulators have probably got it right in their push for better capitalized banks. As an example, the Financial Times article cites indicative yields of 7.6% for convertible instruments (i.e., contingent equity) for Barclays Bank and shows that the true cost of equity is probably lower than the 11.5% estimates articulated by Barclays — the rationale is that the convertible yield provides a proxy for a scenario in the future when there would be greater equity levels due to conversion of the current debt instruments into equity capital.
Too Much Bank Debt Is Not Cheap
Another argument against the notion of expensive equity is provided in the Stanford University working paper. The paper suggests that those who argue that equity capital is expensive tend to overlook the costs associated with the implied stated guarantee towards banks. For banks in particular, any assumption of a low cost of debt, regardless of situations of high levels of leverage, can only be made due to the implied state guarantee towards this sector. Implied state guarantee would reduce the anticipated bankruptcy costs associated with high leverage. In other words, anticipated bankruptcy costs ought to be reflected in the cost of debt but may not be due to the implied state guarantee. That being said, the implied state guarantee is still a component of cost of capital, albeit a social cost.
Regardless of the implied state guarantee possibly having historically lowered the apparent cost of debt, its availability is likely to diminish based on lessons learnt by governments during the sovereign debt crisis, where it has been evident that governments can be bankrupted due to their efforts towards rescuing the financial sector. Hence, low bond yields for highly leveraged banks, if they exist, should only be seen as a reflection of mispricing and a failure to acknowledge the new environmental reality for the banking sector where there should be minimal reliance on state-based rescue actions.
Investors Should Not Simply Focus on Return on Equity
A final point to make is that some bankers have also tended to bemoan the likely shrinkage in return on equity (ROE) due to increased equity capital levels. But again this misses the mark. Several commentators, including this author in a previous blog post, have cautioned against overreliance on ROE as a performance metric, especially as ROE does not reflect returns on a risk-adjusted basis. All in all, despite the protests by some in the banking sector, the regulatory push for greater levels of equity for banks is a sound policy choice.
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