The Definition for Cost of Capital and The Banks

Recalling 4 years back , the world’s largest banks have been up in arms over threats by regulators to increase their A(equity) capital requirements. Making banks hold more capital, they argue, will force them to reduce lending and will increase their cost of funding, making credit more expensive throughout the economy. One of the chief defenders of the mega banks has been Josef Ackermann, CEO of Deutsche Bank until last year and also chair of the Institute of International Finance, which claimed that higher capital requirements would reduce economic output by a whopping 3.2 percent.

Was going through the new book by Anat Admati and Martin Hellwig The Banker’s New Clothes they have been tirelessly debunking the myth that higher capital levels will force banks to curtail lending and torpedo the global economy,. Some of the arguments against higher capital requirements are simply incoherent, like the idea that banks would be forced to set aside capital instead of lending it. (Capital is the difference between assets and liabilities, not cash that you put somewhere for safekeeping; were it not for reserve requirements, which are something else, a bank could lend out 100 percent of the money it can raise.)
Some contradict basic principles of corporate finance, like the idea that adding more equity capital increases banks’ cost of funding.* Yes, equity is usually more expensive than debt (meaning that investors demand a higher expected rate of return) because it is riskier (the range of possible outcomes is greater). But as you add equity, both the debt and the equity become less risky (since the firm is less leveraged), which reduces the cost of debt and the cost of equity. According to Modigliani-Miller, the two effects balance out perfectly, given a few assumptions.

Revisiting my corporate finance class – In the real world, debt has a tax advantage (interest on debt is tax-deductible, while cash that is paid to shareholders or reinvested in operations is not), so increasing debt can reduce the overall cost of financing. But that’s a government subsidy. Lower leverage might increase banks’ funding costs, but would reduce taxpayer subsidies; to a first approximation, this would make society better off, not worse off (since subsidies are distorting).

Well, until last week. That’s when Deutsche Bank raised almost €3 billion by selling new stock. And what happened? Its stock closed up 3.7 percent.** (The S&P 500 was up 0.7 percent.)

What does that mean? Well, the big banks would have you believe that equity is “expensive,” so forcing banks to to issue more equity is bad for them and will increase their funding costs (which they will pass on to the rest of us). In this case, however, Deutsche Bank’s shareholders clearly thought that selling new stock was a good thing, since it made the bank more valuable. And it couldn’t possibly have raised the banks overall cost of capital (including both debt and equity): if you change your capital structure, your operations don’t change, and the value of your company goes up, that means that your cost of capital must have gone down. In other words, Deutsche Bank was leveraged past its optimal debt-to-equity ratio, even leaving aside societal considerations, so issuing new equity (raising capital, in banking parlance) was a good thing. It made both their debt and their equity less risky, reducing their cost of capital.

Of course, the big banks aren’t going to stop whining about capital requirements anytime soon. This is just further evidence that the global economy—and the banks themselves—would be just fine with more capital.

So who would be worse off? Well, anyone whose bonus is tied (asymmetrically) to return on equity, for starters.

Unfortunately, “capital” means something different in the banking world than in the corporate finance world. In the former, capital is the difference between assets and liabilities, and is a rough synonym for equity—rough because, by regulation, some types of liabilities are counted as some types of capital. In corporate finance, capital refers to financing in general; the weighted average cost of capital, for example, includes the cost of both debt and equity.

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