Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is not Expensive

Abstract

We examine the pervasive view that "equity is expensive," which leads to claims that high capital requirements are costly and would affect credit markets adversely. We find that arguments made to support this view are either fallacious, irrelevant, or very weak. For example, the return on equity contains a risk premium that must go down if banks have more equity. It is thus incorrect to assume that the required return on equity remains fixed as capital requirements increase. It is also incorrect to translate higher taxes paid by banks to a social cost. Policies that subsidize debt and indirectly penalize equity through taxes and implicit guarantees are distortive. Any desirable public subsidies to banks' activities should be given directly and not in ways that encourage leverage. And while debt's informational insensitivity may provide valuable liquidity, increased capital (and reduced leverage) can enhance this benefit. Finally, suggestions that high leverage serves a necessary disciplining role are based on inadequate theory lacking empirical support. We conclude that bank equity is not socially expensive, and that high leverage is not necessary for banks to perform all their socially valuable functions, including lending, deposittaking and issuing money-like securities. To the contrary, better capitalized banks suffer fewer distortions in lending decisions and would perform better. The fact that banks choose high leverage does not imply that this is socially optimal, and, except for government subsidies and viewed from an ex ante perspective, high leverage may not even be privately optimal for banks. Setting equity requirements significantly higher than the levels currently proposed would entail large social benefits and minimal, if any, social costs. Approaches based on equity dominate alternatives, including contingent capital. To achieve better capitalization quickly and efficiently and prevent disruption to lending, regulators must actively control equity payouts and issuance. If remaining challenges are addressed, capital regulation can be a powerful tool for enhancing the role of banks in the economy.

An Empirical Economic Assessment of the Costs and Benefits of Bank Capital in the US

“…Notable papers arguing that the theorem applies to banks include Miller (1995) and Admati et al (2014).…”

The Effects of Bank Regulation on the Relationship Between Capital and Risk

“…The size of banks has in fact been growing in the last decades and this has created concerns for the authorities, facing larger banks with low capital ratios and less stable funding sources (Laeven et al, 2014). 8 An interesting point of view is provided by Admati et al (2010) that analyze the arguments against stringent capital requirements (defined as equity capital requirements) and show how these criticisms can be overcome. Moreover, according to the authors, some of the cons of high capital requirements derive from the fallacies in the literature and in the industry that have produced a distortion in the way capital requirements are interpreted and enforced.…”

Taxes, Banks, and Financial Stability

“…Hence, in the context of capital requirements the question is very important whether equity financing is more expensive than debt financing. Most observers would argue that this is the case, although recently there are also some prominent arguments against this idea (see Admati et al, 2011) Nevertheless, similar incidence concerns may apply as in the case of taxes. Even so, there is one fundamental difference between the two, namely who controls the funds.…”