Bank Leverage, Capital Requirements and the Implied Cost of (Equity) Capital

Abstract

Do heightened capital requirements impose private costs on banks by adversely affecting their cost of capital? And if so, does the effect differ across different groups of banks? Using an international sample of listed banks over the period from 1990 to 2017, I find that equity investors adjust their expected return weakly in accordance with the Modigliani and Miller (1958) Theorem when banks decrease their leverage. The adjustment is stronger for smaller banks, banks that rely more on deposit financing and when debt is reduced rather than deposits, which never triggers a statistically significant adjustment. In any cases, the adjustment is not strong enough to keep banks' cost of capital constant which is estimated to increase by 10 to 40bps, representing a relative increase of 2.8% to 12.6%, when shifting equity from 8% to 16%. When using the 2011 EBA capital exercise as a quasi-natural experiment to identify the impact of capital regulation on bank's cost of capital, results indicate a strong reduction in required returns for the treated banks. However, the reduction is mainly caused by shifts in asset risk, highlighting the importance of differentiating between short-run and long-run effects.

Keywords: Bank Leverage, Implied Cost of Capital, EBA Capital Exercise, Capital Requirements, Bank Regulation, Modigliani-Miller

JEL Classification: C33, G21, G28, G32