Abstract

http://ssrn.com/abstract=1669704
 
 

References (254)



 
 

Citations (67)



 


 



Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive


Anat R. Admati


Stanford Graduate School of Business

Peter M. DeMarzo


Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Martin F. Hellwig


Max Planck Institute for Research on Collective Goods; University of Bonn - Department of Economics

Paul C. Pfleiderer


Stanford Graduate School of Business

March 23, 2011

MPI Collective Goods Preprint, No. 2010/42
Rock Center for Corporate Governance at Stanford University Working Paper No. 86
Stanford Graduate School of Business Research Paper No. 2065

Abstract:     
We examine the pervasive view that “equity is expensive,” which leads to claims that high capital requirements are costly and would affect credit markets adversely. We find that arguments made to support this view are either fallacious, irrelevant, or very weak. For example, the return on equity contains a risk premium that must go down if banks have more equity. It is thus incorrect to assume that the required return on equity remains fixed as capital requirements increase. It is also incorrect to translate higher taxes paid by banks to a social cost. Policies that subsidize debt and indirectly penalize equity through taxes and implicit guarantees are distortive. Any desirable public subsidies to banks’ activities should be given directly and not in ways that encourage leverage. And while debt’s informational insensitivity may provide valuable liquidity, increased capital (and reduced leverage) can enhance this benefit. Finally, suggestions that high leverage serves a necessary disciplining role are based on inadequate theory lacking empirical support.

We conclude that bank equity is not socially expensive, and that high leverage is not necessary for banks to perform all their socially valuable functions, including lending, deposit taking and issuing money-like securities. To the contrary, better capitalized banks suffer fewer distortions in lending decisions and would perform better. The fact that banks choose high leverage does not imply that this is socially optimal, and, except for government subsidies and viewed from an ex ante perspective, high leverage may not even be privately optimal for banks.

Setting equity requirements significantly higher than the levels currently proposed would entail large social benefits and minimal, if any, social costs. Approaches based on equity dominate alternatives, including contingent capital. To achieve better capitalization quickly and efficiently and prevent disruption to lending, regulators must actively control equity payouts and issuance. If remaining challenges are addressed, capital regulation can be a powerful tool for enhancing the role of banks in the economy.

Number of Pages in PDF File: 78

Keywords: capital regulation, financial institutions, capital structure, too big to fail, systemic risk, bank equity, contingent capital, Basel, market discipline

JEL Classification: G21, G28, G32, G38, H81, K23

working papers series





Download This Paper

Date posted: October 29, 2010 ; Last revised: November 2, 2013

Suggested Citation

Admati, Anat R. and DeMarzo, Peter M. and Hellwig, Martin F. and Pfleiderer, Paul C., Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive (March 23, 2011). MPI Collective Goods Preprint, No. 2010/42; Rock Center for Corporate Governance at Stanford University Working Paper No. 86 ; Stanford Graduate School of Business Research Paper No. 2065. Available at SSRN: http://ssrn.com/abstract=1669704 or http://dx.doi.org/10.2139/ssrn.1669704

Contact Information

Anat R. Admati (Contact Author)
Stanford Graduate School of Business ( email )
518 Memorial Way
Stanford, CA 94305-5015
United States
650-723-4987 (Phone)
650-725-6152 (Fax)

Peter M. DeMarzo
Stanford Graduate School of Business ( email )
518 Memorial Way
Stanford, CA 94305-5015
United States
650-736-1082 (Phone)
650-725-7979 (Fax)
HOME PAGE: http://www.stanford.edu/people/pdemarzo

National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Martin F. Hellwig
Max Planck Institute for Research on Collective Goods ( email )
Kurt-Schumacher-Str. 10
D-53113 Bonn, 53113
Germany
University of Bonn - Department of Economics
Adenauerallee 24-42
D-53113 Bonn
Germany
Paul C. Pfleiderer
Stanford Graduate School of Business ( email )
518 Memorial Way
Stanford, CA 94305-5015
United States
650-723-4495 (Phone)
650-725-7979 (Fax)

Feedback to SSRN


Paper statistics
Abstract Views: 20,734
Downloads: 4,806
Download Rank: 772
References:  254
Citations:  67

© 2014 Social Science Electronic Publishing, Inc. All Rights Reserved.  FAQ   Terms of Use   Privacy Policy   Copyright   Contact Us
This page was processed by apollo5 in 0.390 seconds