Thursday, 14 June 2018

Modigliani Miller.

The Modigliani Miller theory (MM) states that the costs of funding a corporation are not influenced by the exact way that funding is done: specifically, the claim is that changing the proportion of funding done via equity as opposed to debt will not influence the cost of funding.

That makes MM of importance when it comes to deciding what the best capital ratio is for banks. For example if MM is 100% valid, that means the cost of funding banks is not raised when capital ratios are raised. And if the latter is the correct conclusion then that supports two lots of people: first there are those who want to raise bank capital ratios purely so as to avoid bank crises in the future. Martin Wolf and Anat Admati claim the ratio of equity to debt needs to be about 25:75 for that purpose. The second lot are those who want to raise the ratio to 100% as part of implementing Vollgeld / full reserve banking – although some versions of Vollgeld (e.g. Positive Money’s) do not involve that very high capital ratio.

However there are objections to MM, and one of the most popular objections, if not the most popular, is that equity and debt are not taxed in the same way, thus MM does not work out in practice as per theory.

My answer to that has always been that tax is an entirely artificial imposition which should thus be ignored. I’ve recently realized that’s not quite right: i.e. on further reflection, strikes me the correct answer to the latter tax objection to MM is along the lines of: “if someone implements a tax which discriminates against equity, then the best solution is to remove that distortion, but as long as that is not done, some weight should still be given to MM.” Reasons are as follows.

Assuming MM is 100% valid, then capital ratios might as well be raised to 100% (or to the Wolf/Admati 25% level). That makes bank failures are near impossible. However, given a tax which discriminates against equity, then raising bank capital ratios that far will impose costs on banks, which means a smaller bank sector than is optimum. So what to do?

Well it’s likely that diminishing returns are relevant here: e.g. the benefits of raising the capital ratio from say 3% to 6% will be significant, while the benefits of raising them from 93% to 96% are pretty negligible. Thus given a tax which discriminates against equity, it will be worthwhile abstaining from raising bank capital ratios as far as would be the case where that discrimination does not exist, while at the same time, still going for a finite increase in capital ratios.

For example, cutting capital ratios from 100% to 50% does involve a cut in  GDP in that there’s an increased risk of bank failures, but that increased risk is very small. In contrast, cutting the ratio from 100% to 50% does much to cut bank costs, and thus bring about a bank sector which is near it’s optimum size or “GDP maximizing” size.

But of course working out the optimum position on the latter scale is near impossible, and that explains much of the argument over bank regulation.

But much the simplest and best solution is to remove the artificial discrimination against equity. Then (assuming MM has no other defects) we can fire ahead and raise bank capital ratios to the Wolf/Admati 25%, or even higher if the case for Vollgeld is successfully proven.

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