Working Paper: CEPR ID: DP8333
Authors: David K. Miles; Gilberto Marcheggiano; Jing Yang
Abstract: This paper reports estimates of the long-run costs and benefits of banks funding more of their assets with loss-absorbing capital, or equity. Measuring those costs requires careful consideration of a wide range of issues about how shifts in funding affect required rates of return and on how costs are influenced by the tax system; it also requires a clear distinction to be drawn between costs to individual institutions (private costs) and overall economic (or social) costs. Without a calculation of the benefits from having banks use more equity no estimate of costs--however accurate--can tell us what the optimal level of bank capital is. We use empirical evidence on UK banks to assess costs; we use data from shocks to incomes from a wide range of countries over a long period to assess risks to banks and how equity funding (or capital) protects against those risks. We find that the amount of equity capital that is likely to be desirable for banks to use is very much larger than banks have used in recent years and also higher than targets agreed under the Basel III framework.
Keywords: banks; capital regulation; capital structure; cost of equity; leverage; Modigliani-Miller
JEL Codes: G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increasing equity capital (G24) | Reducing the chance of banking crises (F65) |
| Increasing equity capital (G24) | Reducing systemic risk (G28) |
| Replacing debt with equity (G32) | Rising costs of intermediation (G19) |
| Rising costs of intermediation (G19) | Higher borrowing costs for consumers (G21) |
| Higher borrowing costs for consumers (G21) | Reduced investment levels (G31) |
| Doubling bank capital (G21) | Modest increase in average cost of bank funding (G21) |
| Requiring banks to hold more equity (G21) | Small social costs relative to social benefits (D61) |