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

Abstract

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in AbstractWe examine the pervasive view that "equity is expensive," which leads to claims that high capital requirements are costly for society and would affect credit markets adversely. We find that arguments made to support this view are fallacious, irrelevant to the policy debate by confusing private and social costs, 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. 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 at the levels allowed, for example, by the Basel III agreement is not necessary for banks to perform all their socially valuable functions and likely makes banking inefficient. 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. 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.

Testing the impact of higher capital Requirements on unlisted German banks for a short-term investment period

“…Admati et al, 2015). For more reason why the M/M propositions apply to banks see Miller (1995), Admati et al (2013), andPfleiderer (2015).…”

“…Based on Admati et al (2013), an empirical test to examine the impacts of higher capital requirements on bank's overall cost of capital is provided by Miles et al (2012). Miles et al (2012) find that the cost of capital increases up to 18 basis points for the six largest banks in the UK.…”

“…Elliot (2013) claims that higher bank capital would lead to significant economic costs, a reduced lending, and shifts to less regulated sectors. Against this backdrop, Admati et al (2013) argue that more equity is not socially expensive and that higher capital levels will lead to a better lending performance. Admati et al (2013) motivate their theoretical argumentation with the use of the Modigliani and Miller (M/M) propositions that lower levels of leverage will decrease the risk premium on equity.…”

“…Against this backdrop, Admati et al (2013) argue that more equity is not socially expensive and that higher capital levels will lead to a better lending performance. Admati et al (2013) motivate their theoretical argumentation with the use of the Modigliani and Miller (M/M) propositions that lower levels of leverage will decrease the risk premium on equity. The empirical application is provided by Miles et al (2012), who use the method of the weighted average cost of 1 PhD-student at Andrássy University Budapest, Hungary (david.grossmann@mail.de).…”

“…On this basis, the focus is on unlisted banks because they represent the majority in Germany. We expand the existing literature surrounding Admati et al (2013) and Miles et al (2012) on the impact of higher capital requirements, for its applicability on unlisted German banks. The focus is solely on the cost of capital.…”