On the Non-Neutrality of the Financing Policy and the Capital Regulation of Banking Firms

Abstract

It has been often argued that higher capital requirements are not costly for the banking system, by exploiting a renewed edition of a standard argument from corporate finance, the Modigliani-Miller theorem (1958 and 1963). However, the M&M model must be carefully analysed before endorsing the general statement that “bank equity is not expensive”. In the first part of the paper we argue that banks are not ordinary firms and the M&M framework cannot be easily adapted to analyze their financing (and investment) decisions. It cannot be applied neither before any financing instruments have been issued (ex-ante), nor when debt is already in place (ex-post). In terms of ex-ante analysis we focus on government guarantees (both explicit and implicit) and by using a standard Merton model we formally show how the M&M’s leverage irrelevance theorem is inapplicable. In terms of ex-post perspective we analytically derive the cost of a capital injection for the old shareholders by highlighting how risk-shifting phenomena on banks’ assets, notably when price-to-book values are below one, may increase the overall risk of the bank, and, ultimately, of the financial system as a whole. In the second part of the paper we focus on the key differences between accounting and market-based/financial values. Regulatory capital (which is basically based on accounting values) could be seriously biased when there are significant discrepancies between book values and market values. We argue that market prices (notably price-to-book ratios) should play a primary role in bank supervision. Expectations of future profits embedded in market prices can supply timely information on the effective viability of a bank. To support this thesis we show how a simple model of corporate finance and firm’s valuation can be used to assess bank’s stability by comparing the expectations of bank’s future profits (implicit in market prices) with its cost of funding.