Bank capital regulation and the Modigliani-Miller Theorem: a Post-Keynesian perspective

Abstract This paper challenges the validity for bank regulation of the Modigliani-Miller (MM) Theorems. We argue that 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. Hence, from an endogenous money point of view and Minsky’s Financial Instability Hypothesis (FIH), much of the debate on bank capital adequacy rules is misleading because: First, it is not at a bank’s discretion to decide the mix of its funding when it provides credit. Secondly, bank liability management might have implications for financial stability as far as it reduces the liquidity in the economy. Bank regulation in the lines of MM Theorems misses both points as long as it disregards the endogenous process of money supply and the effects of financial fragility. In this sense, refutation of the validity of MM Theorems for bank regulation lends support to a Minskian cash-flow oriented bank regulation for the detection of Ponzi finances.