Sunday, 8 March 2015

Bank capital is expensive? LOL. Part II.

I dealt here with some flaws in the claim that bank capital is more expensive than debt (i.e. bonds or deposits): in particular claims to that effect were made by the UK’s “Independent Commission on Banking”. In the paragraphs below I’ll examine two more of the ICB’s arguments.

The ICB’s section A3.46.

To recap, the Modigliani Miller theory makes the very simple point that if the proportion of a bank’s funding that comes from shareholders is increased, that simply DECREASES the risk per share or per shareholder. Thus as MM point out, raising bank capital ratios ought to have no effect on bank funding costs.

The ICB rebuts that idea (in the 2nd half of A3.46) with the following obscurely worded two sentences.  “Second, the yield on bank debt is lowered by guarantees. An increase in bank equity reduces the value of this guarantee – a private cost to the bank, but again one that is offset by a reduction in the contingent liability of the government.”

Did you understand that? No – I didn’t either at first reading. At any rate, I assume the ICB is simply making the point that there are various taxpayer funded guarantees for bank creditors: that’s certainly the case with depositors in the UK (deposits are insured by the taxpayer). As to guarantees for bond-holders, there is no EXPLICIT guarantee there, however it is widely accepted that in the recent crisis, the authorities throughout Europe just couldn’t stomach the idea of large numbers of bank bondholders being ruined, which partially explained the billions of taxpayers’ money devoted to bank rescues. Thus it can well be argued that bank bond holders enjoy taxpayer funded guarantees as well.

And clearly, as A3.46 says, if a bank is funded to a greater extent by shares and to a lesser extent by those lovely depositors (and/or bond holders) who enjoy taxpayer backing, then funding the bank will cost more.

But that increased cost stems purely from the removal or partial removal of a subsidy. Indeed, the ICB admits as much when it says the increased cost “is offset by a reduction in the contingent liability of the government.”

So the ICB demolishes it’s own point! So what was the purpose of making the point??

Section A3.47.

This section reads as follows:

“Capital structure affects incentives on managers, and from this perspective there is merit in banks issuing both debt and equity. Bank creditors focus on downside risks, whereas shareholders benefit from upside risks. This makes bank creditors act differently to shareholders, and in particular to exert more control when banks are performing poorly. A combination of debt and equity may therefore induce good risk-taking incentives.”

OK, so the suggestion is that without debt, shareholders would not “focus on downside risks”, or wouldn’t do so to a sufficient extent. That claim is complete nonsense, and for the simple reason that the value of the shares in any corporation is very definitely related to the value of the corporation. Thus if the corporation is run incompetently, the value of the corporation drops, as do the value of the shares. So whence the ICB’s bizarre claim that shareholders are not motivated to think about the downside?

Of course, if a corporation is funded just by shares rather than say 50% by shares and 50% by bonds, the EXACT WAY and pace at which shares lose value as the corporation declines is altered. But that’s an minor technicality. The important point is that when a corporation performs poorly, its shareholders lose out (unless I’ve completely lost contact with reality).

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