On the Relevancy of Modigliani and Miller to Banking: A Parable and Some Observations
9 Pages Posted: 17 Dec 2010
Date Written: December 17, 2010
Discussions of bank capital regulation are often clouded by fundamental misunderstandings about how the insights presented over 50 years ago by Modigliani and Miller (M&M) relate to bank funding and the cost of bank equity. The claim is often made that banks are special and that the M&M insights do not apply in the banking context. This claim is misleading and false. The M&M insights, when properly interpreted, do apply to this discussion. These insights show that any analysis of capital regulation must be focused on how capital regulation rules affect the various frictions associated with funding and how this affects the social costs and benefits associated with the funding of banks. This short paper presents a parable that explains the relevance of M&M to banks and makes several observations about the errors and incorrect arguments that result when M&M insights are not properly recognized.
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