Banks' arguments against stricter capital reserve requirements seem to be getting a hearing from regulators such as Tim Geithner and the Basel Committee, but a recent paper suggests they should not.
This was alluded to in a blog today by Simon Johnson over at the Baseline Scenario, but the relevant passages are worth reading.
The paper isn't authored by lightweights but by Samuel Hanson and Jeremy Stein of Harvard and Anil Kashyap of the University of Chicago.
Here's what they say in response to the bank lobby's contention that forcing banks to hold more equity instead of debt will impair their ability to lend, and thus prevent the economic recovery from strengthening or even abort it: "The fallacy here is that the risk of equity, and hence its required return, is not a constant, but rather declines as leverage falls."
To back up their contention, they cite previous research on their part that shows this is particularly true for large banks. And they note that the famous finance theory known as Miller-Modigliani, named after the Nobel laureate economists Merton Miller and Franco Modigliani who developed it, posits that were it not for their differing tax treatment, the cost of debt and equity would be equal.
(Here I have to note that an economist at Goldman Sachs once relied on this theory to encourage me to write a piece while I was at CFO extolling the use of leverage by non-financial corporations that he contended had too much equity in their capital structure. And he didn't say the theory didn't apply to banks.)
The one exception that this theory allows for, is during times of financial stress, but in that case, equity is actually cheaper than debt.
And in normal times and adjusted for the effect of the deductibility of interest, the authors found that even a 10 percentage point increase in capital requirements would amount to a cost advantage for debt of a mere 35 basis points.
So is this finding merely theoretical, that is, with no real-world application? The authors examined the history of US bank capital structure and lending going back to the 19th century and found no correlation between the two, but instead a lot of what they called "noise."
And they note that the existence of smaller banks with higher ratios suggests that capital has little effect on lending.
"Consistent with our M-M-based calibration exercise," the write, "even several additional percentage points of capital need not imply prohibitively large effects on lending rates-for if they did, it would be hard to understand how the smaller community banks have managed to stay in business without being evolved away."
As for the unintended and what they call the most serious potential consequence of higher capital requirements, that is, that it would drive more assets off of bank balance sheets and into the so-called "shadow" banking system through asset-backed securitization, the authors say regulators should deal with that potential problem by, well, regulating it. They recommend, for example, requiring investors to accept a discount on asset-backed securities to reflect the fact that little equity is backing them (the new financial reform law will require 5 percent for the first time), and thus pose higher risk.
So why are regulators once again running scared of the bank lobby?