Bank capital requirements: Are they costly?

David Miles, 17 January 2013

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There exists a widespread view that having banks use more equity capital (and relatively less debt) to finance the assets they hold creates substantial costs, costs that may be so great as to make more capital infeasible. I believe that these costs are very substantially exaggerated. But the benefits of having banks that are far more robust – in the sense of having a balance sheet structure that makes them much less likely to come near to insolvency once actual and suspected losses on their assets come along – are likely to be large.

Scepticism about costs

I want to focus on the cost side of this and briefly explain why I am sceptical that those costs are likely to be so large.

I begin with a simple point: in many countries, banks used to finance a very much higher part of their activities with equity than is considered acceptable today. This was certainly the case in the UK. Figure 1 shows a measure of assets relative to equity and reserves for UK banks over the past 100 years or so.

Between 1880 and 1960 bank leverage was, on average, about half the level of recent decades. Spreads between reference rates of interest and the rates charged on bank loans were not obviously higher then when banks made very much greater use of equity funding. Bank of England data show that spreads over reference rates on the stock of bank lending to households and companies since 2000 have averaged a bit above 2%. Evidence indicates that the spread over bank rate of much bank lending during the first half of the 20th century was consistently below 2% – though bank leverage was generally very much lower then, as Figure 1 shows. Until proven otherwise, this is evidence that much higher levels of bank capital do not cripple development or seriously hinder the financing of investment.

Evidence from the US

The absence of any clear link between the cost of bank loans and the leverage of banks is also evident in the US. Figure 2 shows a measure of the spread charged by US banks on business loans over the yield on treasury bills. The chart shows that the significant increase in leverage of the US banking sector over the 20th Century was not accompanied by a decrease in lending spreads, indeed the two series are mildly positively correlated so that as banks used less equity to finance lending, the spread between the rate charged on bank loans to companies and a reference rate actually increased. Of course such a crude analysis does not take in to account changes in banks’ asset quality, or in the average maturity of loans, or changes in the degree of competition. Nevertheless, this evidence provides little support for claims that higher capital requirements imply a significantly higher cost of borrowing for firms.

Figure 1. UK banks’ leverage

Source: United Kingdom: Sheppard, D (1971), The growth and role of UK financial institutions  1880-1962, Methuen, London; Billings, M and Capie, F (2007), 'Capital in British banking', 1920-1970, Business History, Vol 49(2), pages 139-162; BBA, ONS published accounts and Bank calculations.

Notes: (a) UK data on leverage use total assets over equity and reserves on a time-varying sample of banks, representing the majority of the UK banking system, in terms of assets. Prior to 1970 published accounts understated the true level of banks' capital because they did not include hidden reserves. The solid line adjusts for this. 2009 observation is from H1.

(b) Change in UK accounting standards.

(c) International Financial Reporting Standards (IFRS) were adopted for the end-2005 accounts. The end-2004 accounts were also restated on an IFRS basis. The switch from UK GAAP to IFRS reduced the capital ratio of the UK banks in the sample by approximately one percentage point in 2004.

Figure 2. Leverage and spreads of average business loan rates charged by US commercial banks over three-month treasury bills

Source: Homer and Sylla (1991) A History of Interest Rates, Rutgers University Press.

According to the theory

None of this evidence relies on any clever academic theorising – it just points to what banks used to be like. There is, of course, a bit of theory – not especially complicated and pretty much in line with common sense – which also suggests that the costs to banks of using more equity financing are not likely to be great. The idea here is that while the required return on equity is likely to be greater than the required return on debt – because it is more risky – the extra cost of financing from using more equity is small because extra equity reduces risk and lowers the required return on both debt and equity. I doubt that this offset is so great as to make the cost of debt and equity to a bank the same - the Modigliani-Miller theorem is not likely to hold exactly. But nonetheless the cost of using more equity on the overall cost of funding a banks’ assets is, even on pessimistic assumptions, not likely to be great.

Let me be more specific and run through a very simple calculation (see Miles,Yang, and Marcheggiano 2012). Suppose a bank can raise debt at an interest rate of 5%. Suppose the bank has leverage of 30 (that is, assets are 30 times greater than equity funding). Suppose also that at this degree of leverage the required rate of return on equity is around 15%. These figures are roughly representative of where many banks have been in recent years. The weighted average cost of funds would then be 5.33%. Suppose that if leverage halves to 15, there is some reduction in the required return on equity, but only around half of the reduction implied by the Modigliani-Miller theorem. That would suggest that the required return on equity would fall to 12.6%, and the average cost of funds would rise to 5.5%. If the Modigliani-Miller theorem did not hold at all, the required return on equity would have stayed at 15% and the weighted average cost of capital would have risen to 5.66%.

So a doubling in capital, halving leverage, might cause the cost of bank funding to rise by between 17bp and 33bp. These numbers are nontrivial but hardly enough to do substantial damage to banks and their customers.

The ‘capital requirements are costly’ argument

So why do so many people seem to think that having banks use more equity is so costly? One reason is that some people seem to think that capital is money that is forced to lie idle, that it is ‘tied up’. This obviously makes no sense at all. Equity funding helps finance the acquisition of assets. It is a source of funding for bank lending in exactly the same way that debt is. You might think this is so self-evident that no one could ever believe the notion that requiring banks to use more equity is withdrawing funds from the economy. But I think you would be wrong, at least judging from the number of times you hear the view that higher capital requirements are sucking money out of the economy and starving firms and households of credit.

A rather more subtle argument is that, while in some circumstances equity is not an exceptionally costly form of finance for banks, today it is because bank equity is trading at a huge discount. One version of this argument is that because the ratio of the market value of equity to its book value is well beneath unity, a bank which raises equity is imposing huge costs on those that provide it. I find this argument hard to understand. One interpretation of the argument is that because the market value of existing equity sits well below book value, a bank that raises one pound of new equity and invests in new assets will immediately find that the market value of those assets will fall to well under one pound. But why should one believe that the management of a bank is doomed to repeat whatever historical mistakes have created a situation where assets acquired in the past are now valued at less that the cost of acquisition? Is not a bank manager convinced of this so pessimistic of their own ability that they are in need of therapy, or a change of career?

Another interpretation of the price to book argument is that it shows that required returns on new equity are very high. But a far more natural interpretation is that investors believe that existing assets on a bank’s balance sheet are worth less than their acquisition cost rather than that the required return on new investment is very high. This interpretation is consistent with the analysis on the latest Bank of England Financial Stability Report (Bank of England 2012):

“In June 2012, the market value of the four largest UK banks’ equity was around £90 billion less than the book value. This magnitude is similar to the difference between banks’ own estimates of the fair value of their loans and their book value at the end of 2011. Before the crisis there was little difference between these values. But since 2007, the fair value of UK banks’ loans has fallen significantly below the book value.

The fair value of loans should reflect the present value of expected cash flows. For example, expected credit losses, over and above current provisions or losses priced into loans, reduce the fair value of loans below their book value.”

One convincing argument

The argument as to why raising more equity capital is problematic for banks that I think makes most sense is that the benefit of extra capital may substantially accrue to those with debt claims, making it unattractive to new shareholders. This is a debt overhang problem:

  • First, while it may help explain difficulties for banks in raising more equity it also means that failure to raise more equity is a huge obstacle to a bank being able to function properly.

Not raising more equity would leave a bank with a cushion against losses too low to make it able to raise debt easily – that is precisely the debt overhang phenomenon in another guise.

  • Second, one way to handle the debt overhang problem is to have some debt convert to equity. That is why regulators are surely right to think that having banks issue more convertible debt is one means to make them more robust.

Conclusions

What are the people that run banks really saying if they argue that it is very costly – even unfeasible – to use more equity funding? One interpretation is that this argument is an admission that they cannot run a private enterprise in a way which makes people willing to provide finance whose returns share in the downside and the upside. In other words, they are not able to convince people who will face the full consequences of their commercial decisions to provide funding. It is as if banks cannot play by the same rules as other enterprises in a capitalist economy – after all, capitalists are supposed to use capital. You might expect that if this is the assessment of many people who currently run banks, then they would not wish to proclaim it so loudly.

Disclaimer: The views expressed here are those of the author and do not necessarily represent those of the institutions with which he is affiliated.

References

Miles, D, J Yang, and G Marcheggiano (2012), “Optimal Bank Capital”, The Economic Journal, June.

Bank of England (2012), “Financial Stability Report”, 32, November.

Topics: Financial markets
Tags: banking, Central Banks, debt capital, equity capital

David Miles
Monetary Policy Committee Member, Bank of England

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