Higher capital (Basel III) requirements are criticized by banks: it is detrimental to growth because of the higher cost of credit. This assertion contradicts one of the most central propositions of finance, named after the founding fathers: the Modigliani-Miller proposition (1958). So I feel uncomfortable with the bankers’ stance. Let me explain this. Every business uses money to invest. In order to invest, a business has to raise the cash for the investment. A business can use two sources of finance: (shareholder’s) equity and debt. A debtholder is entitled to future repayment and interest. A shareholder is entitled to dividend but the company is not obliged to pay it. Equity is permanent capital, the price paid for the shares is in principle not refunded. So equity creates a buffer for difficult times. The higher capital requirements mean that the level of equity compared to debt must rise.
The costs of equity are higher than for debt because shareholders have to be compensated for the higher risk (the equity premium). Suppose a bank is financed with 50% equity and 50% debt. The cost of debt is 5%, of equity 10%, so the weighted average cost of capital (WACC) is 7.5%. Is it possible to reduce the WACC of the company by substituting equity for debt? It seems profitable to finance the business with debt only because the cost of debt is lower. This seems like easy money making: a free lunch. The WACC decreases to 5% (and the value goes up)! But of course debtholders cannot be fooled because in this case they bear all the risks (and have become shareholders and debtholders at the same time). The financing decision is irrelevant for the WACC: the value of a business comes from your investments, not the way you financed them.
Why do banks use so many debt funds? The world of Modigliani and Miller is a perfect world. But there are imperfections: in the case of banks, two distortions are important: taxes and explicit and implicit governmental guarantees to depositors. Interest paid to debtholders is tax deductible, dividend is not. So taxes can be diminished by debt financing. There is an additional reason that debt increases the value of a banking business: because of governmental guarantees the bank is able to borrow cheap (because the risk for the depositors is low). Both are private benefits, but not social. In fact a large subsidy flows to the banks that distorts incentives and creates negative externalities, because banks can “gamble with other people’s money” (Roberts, 2010). The social costs of capital requirements, if any, are minimal.
What about the benefits of capital requirements? Banks are very complicated institutions and connected with many other banks. So it is not suitable to approach the risks of bank failure (a bank run) in isolation. System banks, in particular, can influence many other markets and institutions. This is called systemic risk. What are the benefits of reducing systematic risk (as a result of reduced bank failure)? Haldane (2010) shows that GDP losses can be very high. In general, the loss of GDP (due to higher private costs of debt) is very low compared to the very high incidental loss of GDP during a financial crisis. Setting equity requirements significantly higher than the levels currently proposed would entail large social benefits and minimal, if any, social costs. Basel III capital requirements are still very low. Besides that, they are very complex. The Basel rules contain hundreds of pages with detailed requirements. Meeting the Basel III rules alone, Europe’s banks will have to create 70,000 new full time compliance jobs (Haldane, 2012).
Essentially, capital requirements (and other bank regulations such as living wills) ultimately boils down to one decision: what is the level of risk society accepts for the operation of the banking system? Systemic risk results from a type of tragedy of the commons in which market participants lack sufficient incentive, absent regulation, to limit risk-taking in order to reduce the systemic danger to others. Law therefore has a role in reducing systemic (economic) risk (Schwarcz, 2008). Capital requirements are a useful instrument to mitigate systemic risk. Law and economics (of banking) are connected. But in fighting complexity, we need more simple rules than Basel III requirements that add complexity. The social benefits of Basel III could be higher.
Want to read more?, see “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulations” (Admati et al., 2011).