In the aftermath of the financial crisis, there have been numerous calls for banks to finance themselves less with debt and more with equity, to reduce the risk of another crisis. But this has been met with great resistance by bankers. They argue that equity is costlier than debt, and so forcing them to use more equity will make it more expensive for them to raise capital. If they can’t raise as much capital, they won’t be able to lend as much to small businesses and homeowners; if it’s more expensive to raise capital, they’ll need to take on riskier projects to generate a high enough return to meet their cost of capital. For example, Jamie Dimon of JP Morgan has said (paraphrased): “If they force us to hold more equity, we will have to take on riskier projects to hit our required return on equity”.
The Modigliani-Miller theorem, taught in undergrad or MBA finance 101, tells us that (under certain conditions), firm value is independent of capital structure – equity is no more costly than debt. Indeed, Jamie Dimon’s seemingly intuitive argument involves not one, not two, but three violations of basic finance theory:
- It treats the required return on equity as a constant (as if it were pi or Avogadro’s number). But, basic finance theory tells us that it depends on financial risk. If the firm is financed by more equity, it’s less risky, and so shareholders demand a lower return on equity. Banks won’t need to take on more risk, because the target will have fallen.
- Basic finance theory tells us that the required return on equity also depends on business risk. If the firm “takes on riskier projects”, shareholders will demand a higher return as a result. Thus, banks won’t have an incentive to take on more risk, because this will cause the target to rise.
- Equity is not something that you “hold”. It doesn’t sit idly on the balance sheet doing nothing – the bank can invest or lend the money raised by equity. Equity isn’t an asset, it’s a liability – it’s how a bank finances itself. If a firm finances itself with equity rather than debt (changes its liability mix), it needn’t change the projects it invests in (its asset mix).
The fallacies inherent in most bankers’ arguments are exposed in Anat Admati and Martin Hellwig’s influential book “The Bankers’ New Clothes“; see this link for non-technical articles on this topic. However, some bankers may counter that the Modigliani-Miller theorem doesn’t hold in the real world. There are valid reasons for why it’s advantageous to finance with debt rather than equity – debt gives tax shields, and incentivizes management to work harder to avoid bankruptcy.
But a new paper by Roni Kisin and Asaf Manela of the Olin School of Business at Washington University in St. Louis exposes these arguments – using banks’ own actions! They find that bankers’ own behavior suggests that they don’t view debt as useful – that the above advantages of debt are small in the real world. Their identification is clever. They exploit the fact that, prior to the crisis, banks had access to a loophole – asset-backed commercial paper conduits (a form of securitization) that allowed them to lower their equity capital requirements by 90%.
Using these conduits was costly – the interest rate on asset-backed commercial paper is higher than that on directly-issued commercial paper (which didn’t benefit from the loophole). Thus, banks traded off the benefits (of reducing equity capital requirements) with the costs of using the conduit. If financing themselves with equity, rather than debt, truly was costly, banks would have used the conduits to a large degree – particularly since the availability of the loophole was well-known to all banks.
But they didn’t. Roni and Asaf estimate that, based on the limited usage of these conduits, it’s not costly for banks to finance themselves with equity. Even if banks were to increase their equity ratios from 6% to 16%, this would cost all U.S. banks in aggregate $3.7 billion. The average cost per bank is $143 million, or 4% of annual profits. Lending interest rates would rise by 0.03% and quantities would decrease by 1.5%. While the above numbers are not small, they are far lower than the numbers branded around by bankers, and arguably a small price to pay to substantially reduce the risk of another crisis.
One caveat is that the authors are clear that they quantify the cost of increasing equity capital requirements, rather than the cost of increasing equity capital. It may be that the cost of increasing equity capital requirements is low, not because the cost of raising equity is low, but because banks have other ways of complying with the requirements (e.g. other loopholes, or changing the riskiness of the assets they invest in). Nevertheless, the paper provides innovative evidence that increasing capital requirements is much lower than what many banks claim.