Saturday, 30 January 2016

Hoenig falls for the popular myth that bank capital is expensive.

Federal Deposit Insurance Corp Vice Chairman Thomas Hoenig says that requiring banks to fund themselves via more capital or capital/equity like instruments like bonds that can be bailed in will raise bank funding costs and hence force banks to make more risky loans to cover those costs.

Anat Admati, economics prof at Stanford, would be able to explain to Hoenig why capital is no more expensive than debt. But I’ll run thru the argument very briefly for the umteenth time. It’s very simple.

If a given bank is funded ENTIRELY by capital, the risks run by capital holders are EXACTLY THE SAME as if the bank is funded entirely or almost entirely by debt. E.g. if the chance of the bank’s assets declining to X% of book value are 1/Y in any given year when the bank is funded entirely by capital, then the chances of the same thing happening when the bank is funded by debt will be exactly the same. Ergo the charge made by debt holders and capital holders for funding the bank will be the same.

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