Bank Capital and the Modigliani-Miller Theorem When Loans Create Deposits

36 Pages Posted: 28 Mar 2019

See all articles by George Dotsis

George Dotsis

National and Kapodistrian University of Athens - Faculty of Economics; Essex Finance Centre, Essex Business School, University of Essex

Date Written: March 5, 2019

Abstract

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

Dotsis, George, Bank Capital and the Modigliani-Miller Theorem When Loans Create Deposits (March 5, 2019). Available at SSRN: https://ssrn.com/abstract=3347104 or http://dx.doi.org/10.2139/ssrn.3347104

George Dotsis (Contact Author)

National and Kapodistrian University of Athens - Faculty of Economics ( email )

Greece

HOME PAGE: http://sites.google.com/site/gdotsis/

Essex Finance Centre, Essex Business School, University of Essex ( email )

Wivenhoe Park
Colchester, CO4 3SQ
United Kingdom

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