Do Strict Capital Requirements Raise the Cost of Capital? Banking Regulation and the Low Risk Anomaly
53 Pages Posted: 4 May 2013 Last revised: 19 Jun 2023
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Would Stricter Capital Requirements Raise the Cost of Capital? Bank Capital Regulation and the Low Risk Anomaly
Do Strict Capital Requirements Raise the Cost of Capital? Bank Regulation, Capital Structure, and the Low Risk Anomaly
Do Strict Capital Requirements Raise the Cost of Capital? Banking Regulation and the Low Risk Anomaly
Would Stricter Capital Requirements Raise the Cost of Capital? Bank Capital Regulation and the Low Risk Anomaly
Date Written: May 2013
Abstract
Minimum capital requirements are a central tool of banking regulation. Setting them balances a number of factors, including any effects on the cost of capital and in turn the rates available to borrowers. Standard theory predicts that, in perfect and efficient capital markets, reducing banks' leverage reduces the risk and cost of equity but leaves the overall weighted average cost of capital unchanged. We test these two predictions using U.S. data. We confirm that the equity of better-capitalized banks has lower systematic risk (beta) and lower idiosyncratic risk. However, over the last 40 years, lower risk banks have higher stock returns on a risk-adjusted or even a raw basis, consistent with a stock market anomaly previously documented in other samples. The size of the low risk anomaly within banks suggests that the cost of capital effects of capital requirements may be considerable. Assuming competitive lending markets, banks' low asset betas implied an average risk premium of only 40 basis points above Treasury yields in our sample period; a calibration suggests that a ten percentage-point increase in Tier 1 capital to risk-weighted assets may have increased this to between 100 and 130 basis points per year. In summary, the low risk anomaly in the stock market produces a potentially significant cost of capital requirements.
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