Commercial Bank Capital Debt, Business Risk, and Stock Price

Abstract

A major implication of this article is that commercial banks, and business firms in general, might benefit significantly from the application of capital market theory to their business assets. Even unlevered firms would enhance the relative increase in return given the additional risk to personally levered investors if firms moved their business strategies toward the optimal risky portfolio. Thus, whether personal or corporate leverage is used is not central to this study's focus. The point is that the combination of changes in business strategy and financial leverage can increase investor return with no change in risk.

It is interesting to note that the probable impact on the conclusions of the possible use by commercial banks of floating-rate capital debt. Of course, the zero variance of the debt cost characteristic necessary to support the theoretical conclusions disappears with floating-rate debt. Thus, much of the market interest rate risk is transferred from the debt holders to the bank, thereby leading to the a priori conclusion that banks are paying lower expected interest rates on floating-rate debt than would have been the case with equivalent fixed-rate debt (the latter being a safe asset from the bank's viewpoint and, therefore, a risky asset from the investor's viewpoint). Whether floating-rate capital debt increases or decreases the bank's value to common stock investors is a difficult theoretical and empirical question that depends on many variables, including the future level of interest rates, the covariance between market interest rates, bank portfolio returns, deposit costs, and so on. Therefore, it is not possible to state on an a priori basis whether the trading of a safe asset (represented by fixed-rate bank capital debt) for a particular risky one at a possibly lower cost to the bank is justified in terms of its impact on the bank's stock price.

In addition, the stock price of levered (capital debt) banks outperformed un-levered banks over the period 1962-1966. Levered banks simultaneously offered the equity market a higher increase in returns and a larger reduction in risk than un-levered banks. Levered banks were more conservative in their business investments in 1966 than in 1962, and therefore earned a lower return on total capital. However, their use of favorable financial leverage via capital debt more than offset the reduced business returns.

The risk to equity in levered banks decreased over the period 1962-1966. This occurred because their reduced business risk more than offset the increased risk to equity through issuance of capital debt. The risk to equity in un-levered banks remained virtually unchanged because they changed neither their business risk nor capital structure.