The Cost of Capital for Banks
64 Pages Posted: 16 Apr 2019 Last revised: 31 Dec 2019
Date Written: December 16, 2019
We use analyst earnings forecasts to extract cost of capital measures for banks. Both the cost of equity and debt capital are decreasing in the tier 1 ratio, whereas total cost of capital is independent of the tier 1 ratio. Our findings suggest that investors adjust their expectations in accordance with the conservation of risk principle (Modigliani and Miller, 1958), also around episodes of equity issuances. Extrapolating from our results; a 10 pp increase in the tier 1 ratio is associated with a 2-8 bps increase in customer borrowing rates due to a loss of tax shield. Finally, we find that increased deposits and off-balance sheet liabilities tend to lower total cost of capital.
Keywords: Bank funding, Cost of equity, Total cost of capital, Leverage effect, Capital buffers
JEL Classification: G21, G28, L51
Suggested Citation: Suggested Citation