52 Pages Posted: 16 Mar 2013
Date Written: March 15, 2013
Capital requirements for banks must balance 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 would reduce the risk and cost of their equity but leave the overall weighted average cost of capital unchanged. We test these two predictions empirically. We confirm that the equity of better-capitalized banks has both lower systematic risk (beta) and lower idiosyncratic risk. However, over the last 40 years in the United States, lower risk banks have higher stock returns on a risk-adjusted or even a raw basis, a pattern consistent with a stock market anomaly previously documented in other samples. A simple calibration using historical data suggests that a ten percentage-point increase in Tier 1 capital to risk-weighted assets would have increased the weighted average cost of capital by between 60 and 90 basis points per year. In competitive lending markets, a change of this magnitude would have doubled or tripled spreads, because bank asset betas implied an average risk premium of only 40 basis points above Treasury yields over that same period.
Keywords: Capital Requirements, Banking, Low Risk Anomaly, Capital Asset Pricing Model
JEL Classification: G02, G12, G21
Suggested Citation: Suggested Citation
Baker, Malcolm P. and Wurgler, Jeffrey, Would Stricter Capital Requirements Raise the Cost of Capital? Bank Capital Regulation and the Low Risk Anomaly (March 15, 2013). Available at SSRN: https://ssrn.com/abstract=2233906 or http://dx.doi.org/10.2139/ssrn.2233906