Wednesday, 27 August 2014
Modigliani & Miller are right on bank capital.
I argued yesterday that the cost of raising bank capital requirements to 25% or even 100% was zero, because that’s what the Modigliani Miller (MM) theory says. I also pointed out that criticisms of MM are feeble.
After a bit of Googling and rummaging around, I now find that the criticisms are even more feeble that I thought. Details as follows.
Lev Ratnovski in a Voxeu paper entitled “How much capital should banks have” suggests just two possible weaknesses in MM. One, (para starting “There are two ways…) is that if you ASSUME the return on bank capital is 15% and the return on bank debt is 5%, then the more capital there is, the higher the cost of funding the bank. Well of course, but it’s PRECISELY the latter sort of 15%/5% assumption that MM proved to be a nonsense. Ratnovski’s point there is a bit like saying “assuming the Earth is flat we wouldn’t be able to have weather satellites”.
The second possible weakness in MM that Ratnovski cites is the taxation point I referred to yesterday, and which, as I explained yesterday, is nonsense. Plus Ratnovski cites another paper on MM (by Anil Kashyap and others). But that paper ALSO has no criticism of MM other than the latter flawed tax point (see p.4 in particular).
MM passes the test with flying colours.
The conclusion is that while the PROCESS of raising bank capital may involve temporary or transient costs, a permanent and higher capital ratio (25%, 50% or even 100%) is costless.
Or to be more exact, it brings net benefits in that bank subsidies and state support for banks is removed.