Bank capital requirements: Are they costly?

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

There exists a view that having banks use more equity capital (and relatively less debt) to finance the assets they hold creates substantial costs, costs that may be so great as to make more capital infeasible. David Miles, in a VOXEU communique (Jan. 17^th), believes that these costs are exaggerated. But the benefits of having banks that are far more robust – in the sense of having a balance sheet structure that makes them much less likely to come near to insolvency once actual and suspected losses on their assets come along – are likely to be large.

Banks used to finance a very much higher part of their activities with equity than is considered acceptable today. Bank leverage before 1970 in the UK was, on average, about half the level of recent decades. Spreads between reference rates of interest and the rates charged on bank loans were not obviously higher then when banks made very much greater use of equity funding. 

There is no clear link between the cost of US bank loans and the leverage of US banks. The significant increase in leverage of the US banking sector over the 20th Century was not accompanied by a decrease in lending spreads, indeed the two series are mildly positively correlated so that as banks used less equity to finance lending, the spread between the rate charged on bank loans to companies and a reference rate actually increased.

Miles made some assumptions about bank returns to determine their cost of capital.  If the required return on equity is set at 15% with a cost of debt of 5%, the weighted average cost of capital would have risen to 5.66% and leverage of 30 times.  If capital is doubled and leverage reduced to 15 times, it might cause the cost of bank funding to rise by between 17bp and 33bp. These numbers are nontrivial but hardly enough to do substantial damage to banks.

A rather more subtle argument is that, while in some circumstances equity is not an exceptionally costly form of finance for banks, today it is because bank equity is trading at a huge discount. One version of this argument is that because the ratio of the market value of equity to its book value is well beneath unity, a bank which raises equity is imposing huge costs on those that provide it.

Another interpretation of the price to book argument is that it shows that required returns on new equity are very high. But a far more natural interpretation is that investors believe that existing assets on a bank’s balance sheet are worth less than their acquisition cost rather than that the required return on new investment is very high.  The fair value of loans should reflect the present value of expected cash flows.

The argument as to why raising more equity capital is problematic for banks is that the benefit of extra capital may substantially accrue to those with debt claims, making it unattractive to new shareholders. This is a debt overhang problem: first, failure to raise more equity is a huge obstacle to a bank being able to function properly with a cushion against losses too low to make it able to raise debt easily; and second, one way to handle the debt overhang problem is to have some debt convert to equity.

What are the people that run banks really saying if they argue that it is very costly – even unfeasible – to use more equity funding? One interpretation is that this argument is an admission that they cannot run a private enterprise in a way which makes people willing to provide finance whose returns share in the downside and the upside. In other words, they are people who will face the full consequences of their commercial decisions to provide funding. It is as if banks cannot play by the same rules as other enterprises in a capitalist economy – after all, capitalists are supposed to use capital. You might expect that if this is the assessment of many people who currently run banks, then they would not wish to proclaim it so loudly. The upside is that bank risks might be priced correctly without a government subsidy.

http://www.voxeu.org/article/bank-capital-requirements-are-they-costly