Bank Capital and the Modigliani-Miller Theorem When Loans Create Deposits
36 Pages Posted: 28 Mar 2019
Date Written: March 5, 2019
This paper argues that banks should not be treated as intermediaries of loanable funds in order to determine optimal bank capital structure. This is because banks create deposits through lending. The Modigliani–Miller analysis cannot be applied to banks because when lending creates deposits the asset side of banks varies together with the liability side and equity behaves more like a sticky variable. In this setting, procyclical high leverage in the banking sector emerges almost mechanically. When banks increase equity through new issues or retained earnings they contract deposits by an equal amount. An empirical study using data on the aggregate balance sheet of all US commercial banks confirms that asset growth is highly correlated with leverage growth and changes in the supply of banks' deposits have a significant impact on liquidity and safety premia. It is argued that adverse changes in deposits' convenience yields due to equity raising by banks could be counterbalanced with asset purchases from the central bank.
Keywords: bank capital, Modigliani–Miller, loans create deposits
JEL Classification: G21, G32
Suggested Citation: Suggested Citation