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Do Strict Capital Requirements Raise the Cost of Capital? Banking Regulation and the Low Risk Anomaly

52 Pages Posted: 17 Mar 2013 Last revised: 22 Apr 2013

Malcolm P. Baker

Harvard Business School; National Bureau of Economic Research (NBER)

Jeffrey Wurgler

NYU Stern School of Business; National Bureau of Economic Research (NBER)

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Date Written: April 18, 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.

Suggested Citation

Baker, Malcolm P. and Wurgler, Jeffrey, Do Strict Capital Requirements Raise the Cost of Capital? Banking Regulation and the Low Risk Anomaly (April 18, 2013). NYU Working Paper No. FIN-13-003. Available at SSRN: https://ssrn.com/abstract=2234557

Malcolm P. Baker (Contact Author)

Harvard Business School ( email )

Boston, MA 02163
United States
617-495-6566 (Phone)

HOME PAGE: http://www.people.hbs.edu/mbaker

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
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Jeffrey A. Wurgler

NYU Stern School of Business ( email )

Stern School of Business
44 West 4th Street, Suite 9-190
New York, NY 10012-1126
United States
212-998-0367 (Phone)
212-995-4233 (Fax)

HOME PAGE: http://www.stern.nyu.edu/~jwurgler/

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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