Bank capital ratios - the incompetent critics of Modigliani Miller.

The Modigliani Miller (MM) theory is defined by Wikipedia as the idea that “the value of a firm is unaffected by how that firm is financed”.  So as regards bank capital ratios, MM says that changing the capital ratio has no effect on the cost of funding a bank and hence no effect on the cost of loans it offers or on total profits. And that is clearly good news for those who want to raise bank capital ratios.

By the same token it is not good news for the pro-bankster “let’s get back to business as usual” brigade. Thus the latter brigade devotes considerable efforts to criticizing MM. Unfortunately some of their efforts are not too clever, to put it politely.

One of the most popular criticisms of MM (in fact THE most popular, far as I can see) is the idea that the tax treatment of dividends is different from the tax treatment of interest, ergo MM does not work out in the real world as per theory. That different tax treatment seems to be relevant for the big “bank capital ratio” argument, since banks are funded in part by dividend earners (holders of bank capital) and in contrast, depositors and bond holders (who earn interest, not dividends).

Astute readers will have spotted the flaw in the latter “tax” argument. But for the benefit of those who have not, the flaw is that tax is an ENTIRELY ARTIFICIAL imposition on corporations: it has nothing to do with the validity or otherwise of MM.

To illustrate, suppose my great new seminal theory states that the cost of making blue cars is the same as the cost of making red cars. Then suppose government imposes a much heavier tax on red cars than blue cars. Would that prove there was something wrong with my “red and blue car” theory? Clearly not.

But the highly qualified academics who cite the above tax point against MM would presumably claim that, by the same token, there was something wrong with the “red and blue car” theory. How dumb can you get?

Just to expand on that, if the red cars were taxed more heavily than blue cars, then on the face of it (i.e. from the point of view of car buyers) red cars would be more expensive than blue cars. But of course from the point of view of the country as a whole, there is no difference between the cost of red and blue cars.

To illustrate, if people switched from blue to red cars, that would mean consumers would be worse off. But it would mean more income for government, which means government could for example cut income tax. Thus consumer / tax payers would be back where they started.

And of course when it comes to bank capital ratios, the important consideration is costs for the country as a whole, not costs for bank customers.


If government has introduced a distortionary tax regime, the best solution is to get rid of the distortion. The distortion is not a brilliant argument for protecting or boosting forms of economic activity that benefit from the distortion.

If you want a list of the so called “professional” economists who cite that tax argument against higher bank capital ratios, i.e. economists who apparently do not understand the latter “red and blue car” point, here they are. At least these are the ones I’ve come across. Doubtless there are several more.

Note that for one of the economists below, the tax criticism of MM is the only one cited, so it’s presumably the only one the relevant author can think of. And for another, only two criticisms are cited, one of which is the tax criticism. So all in all, the tax argument is an important one for the critics of MM.

Birchler, U. & Jackson, P. (2012).  ‘The Future of Bank Capital.’

Elliot, D.J.  (2013).  ‘Higher Bank Capital Requirements Would Come at a Price’. Brookings Institution.

Independent Commission on Banking Final Report, section 3.45.

Kashyap, A.K., Stein, J.C. & Hanson, S. (2010). ‘An Analysis of the Impact of “Substantially Heightened” CapitalRequirements on Large Financial Institutions’. (The tax point is the only criticism cited by Kashyap & Co).

Miles, D., Yang J., and Marcheggiano G. (2011). ‘Optimal Bank Capital’. Bank of England External MPC Unit Discussion paper No.31. Note: the version of this paper referred to here is the April 2011 version, not the January 2011 version.

Ratnovski, L. (2013). ‘How much Capital Should Banks Have?’ Voxeu. (The tax point was one of two criticisms of MM cited by Ratnovski).