Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive

By Anat R. Admati, Peter M. DeMarzo, Martin F. Hellwig, P. Pfleiderer. 2013

890 citations recorded by the source corpus.

We examine the pervasive view that "equity is expensive," which leads to claims that high capital requirements are costly and would affect credit markets adversely. We find that arguments made to support this view are either fallacious, irrelevant, or very weak. For example, the return on equity contains a risk premium that must go down if banks have more equity. It is thus incorrect to assume that the required return on equity remains fixed as capital requirements increase. It is also incorrect to translate higher taxes paid by banks to a social cost. Policies that subsidize debt and indirectly penalize equity through taxes and implicit guarantees are distortive. Any desirable public subsidies to banks' activities should be given directly and not in ways that encourage leverage. Finally, suggestions that high leverage serves a necessary disciplining role are based on inadequate theory lacking empirical support. We conclude that bank equity is not socially expensive, and that high leverage is not necessary for banks to perform all their socially valuable functions, including lending, taking deposits and issuing money-like securities. To the contrary, better capitalized banks suffer fewer distortions in lending decisions and would perform better. The fact that banks choose high leverage does not imply that this is socially optimal, and, viewed from an ex ante perspective, high leverage may not even be privately optimal for banks. Setting equity requirements significantly higher than the levels currently proposed would entail large social benefits and minimal, if any, social costs. Approaches based on equity dominate alternatives, including contingent capital. To achieve better capitalization quickly and efficiently and prevent disruption to lending, regulators must actively control equity payouts and issuance. If remaining challenges are addressed, capital regulation can be a powerful tool for enhancing the role of banks in the economy.

Subfields: Accounting, Economics and Econometrics, Finance

View Paper: https://www.semanticscholar.org/paper/6f6dcd12d0e4f3f5f47888d2eeef11faccfaccff

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Citations in the corpus

Why and How to Design a Contingent Convertible Debt Requirement (2011, neutral): “A recent paper by Admati et al. (2011) has argued that more equity finance might not substantially increase the funding cost of banks.”
Capital requirements, risk choice, and liquidity provision in a business-cycle model (2020, neutral): “The stickines of equity can derive from debt overhang problems (see Admati et al. (2012)) and equity issuance costs.”
Corporate Governance: What’s Special About Banks? (2013, neutral): “…are seen as effective regulatory instruments to prevent banks from taking on excessive leverage, although regulatory arbitrage has allowed banks to circumvent leverage rules in some circumstances, and many argue that minimum capital requirements are set too low (e.g., Admati et al. 2010).”
Bank Capital and Lending Relationships: Bank Capital and Lending Relationships (2017, neutral): “(2008), Gropp and Heider (2010), Shleifer and Vishny (2010), Admati et al. (2013), Baker and Wurgler (2013), Allen, Carletti, and Marquez (2014), Gornall and Strebulaev (2014), Thakor (2014), Acharya, Mehran, and Thakor (2015), DeAngelo and Stulz (2015).”
Bank capital (requirements) and credit supply: Evidence from pillar 2 decisions (2016, critical): “The fact that higher capital requirements lead to lower credit supply seems to indicate that equity capital costs for banks are not negligible, challenging the views of Admati et al. (2013) and Admati and Hellwig (2013).”
Too Much Finance? (2012, neutral): “The test described in (1) and (2) is non-trivial because of the presence of inequality constraints.”
The Rise of Shadow Banking: Evidence from Capital Regulation (2018, positive): “, Admati et al. 2013; Freixas and Rochet 2008), other research examines how alternative features of bank regulation may precipitate nonbank entry into loan markets. Neuhann and Saidi (2016) argue that deregulating the scope of traditional bank activities contributed to the growth of nonbank market s”
The Leverage Ratchet Effect (2017, background): “The results complement our earlier paper (Admati et al. 2013), in which we argued that banks will choose socially inefficient levels of leverage because they do not internalize the significant negative external effect of their distress and default.”
Profitability Determinants of Financial Institutions: Evidence from Banks in Pakistan (2018, neutral): “On the other hand, Admati et al. (2010) concluded that higher equity is not an expense source for banks and the financial system can be stabilized with effective capital regulations.”
Deposits and Bank Capital Structure (2015, neutral): “Much of the recent literature on bank capital structure has been concerned with issues of regulation (e.g., Hellmann et al. (2000), Van den Heuvel (2008), Admati et al. (2010), Acharya et al. (2012)).”