Bank Capital and the Modigliani-Miller Theorem When Loans Create Deposits

Abstract

This paper argues that banks should not be treated as intermediaries of loanable funds in order to determine optimal bank capital structure. This is because banks create deposits through the process of lending. The Modigliani–Miller analysis cannot be applied to banks because when lending creates deposits the asset side of banks varies together with the liability side and equity behaves more like a sticky variable. In this setting, aggregate procyclical high leverage in the banking sector emerges almost automatically. The paper provides some empirical evidence consistent with this view and discusses implications with respect to bank regulation.