Cost of Equity, Enterprise Value and Capital Regulation of Banking Firms

Abstract

It has been argued that higher capital requirements are not expensive for the banking system, by exploiting a renewed edition of a standard argument from corporate finance, the Modigliani-Miller theorem (1958 and 1963). However, the M&M model must be carefully analysed before endorsing the general statement that “bank equity is not expensive”. In fact, specific attention should be posed to three features: a) the role of the banking system as liquidity provider, b) the value of the explicit/implicit government guarantees, and c) the risk-shifting behaviour of banks’ equity holders. To highlight these issues in the first part of the paper we focus on the key differences between accounting and market-based/financial values. We argue that market prices (notably price-to-book ratios) should play a primary role in bank supervision. To support our thesis we present an empirical analysis that shows how market values had a superior signalling content compared to accounting aggregates in predicting banking system distress/losses during the financial crisis. In the second part of the paper we use a standard Merton model to formally show how the M&M’s leverage irrelevance theorem is inapplicable to banks when guarantees are considered. Then, we analytically derive the cost of a capital injection for the old shareholders by highlighting how risk-shifting phenomena on banks’ assets, notably when price-to-book values are below one, may increase the overall risk of the bank, and, ultimately, of the financial system as a whole. A strict and prompt supervision may mitigate, at least in part, the threat of these unintended consequences associated to new capital injections. However, in case of severe stress it seems difficult to eliminate completely this risk shifting incentive. In the third and final part the paper we use a simple model of corporate finance and firm’s valuation to stress that a bank’s stability cannot be achieved if the markets’ expectations of its future profits stay below its cost of funding.

Keywords: Modigliani-Miller, cost of equity, capital regulation

JEL Classification: G13, G21, G28