Thursday, 23 July 2015
Bank capital is not expensive.
Bank capital SEEMS TO BE expensive because bank shareholders demand a higher return than bondholders or depositors. The flaw in that idea was pointed out by Franco Modigliani and Merton Miller, and they got Nobel Prizes for that (amongst other things).
The flaw in the idea that bank capital is expensive is very simple and as follows.
If a bank’s capital ratio is doubled, the risk per shareholder is halved, thus the amount that each shareholder will charge (per dollar of shares) for bearing risk will also halve. Thus the cost of an ADDITIONAL dollar of capital is no more than the cost of an additional dollar of debt.
The Modigliani Miller theory HAS BEEN criticised, but the criticisms don’t amount to much, far as I can see. In particular, the most popular criticism according to this recent article by James Kwak is the idea that in the REAL WORLD, debt is cheaper than capital because “companies can deduct interest payments on debt from their taxable income, but they can’t deduct dividends paid to shareholders” to quote Kwak.
I also pointed out about a year ago that that “tax” point seems to be the most popular criticism of MM. (see top of p.25).
The flaw in that criticism is that tax is an entirely artificial imposition on banks, or indeed any corporation. That is, tax, while it is obviously a cost as viewed by the entity that pays the tax, is not a real cost from the point of view of the country as a whole.
To illustrate, if red cars were taxed more heavily than blue cars, would that mean that the REAL COST of red cars was higher than that of blue cars? Obviously not. Thus that would not be a reason for the country as a whole to give any sort of preference to blue cars.
By the same token, the above point about tax and banks is not a reason to give any sort of preference to bank debt as compared to bank capital.