The Cost of Capital for Banks
67 Pages Posted: 16 Apr 2019
Date Written: March 15, 2019
Expected returns based on analyst earnings forecasts show that when the tier 1 ratio increases the cost of equity and debt capital for banks decreases whereas total cost of capital remains unchanged. These findings are consistent with the conservation of risk principle (Modigliani and Miller, 1958). Empirically, the disadvantages of equity funding are small; a 10 pp increase in the tier 1 ratio preserves total risk but causes a 2.3% loss of firm value due to the lower tax shield. The loss is equivalent to a 2-8 bps increase in borrowing rates. These findings have important implications for the cost of substantially heightened capital requirements.
Keywords: Bank funding, Cost of equity, Total cost of capital, Leverage effect, Capital buffers
JEL Classification: D92, G21, G28, L51
Suggested Citation: Suggested Citation