Working Paper: NBER ID: w19018
Authors: Malcolm Baker; Jeffrey Wurgler
Abstract: Minimum capital requirements are a central tool of banking regulation. Setting them balances a number of factors, including any effects on the cost of capital and in turn the rates available to borrowers. Standard theory predicts that, in perfect and efficient capital markets, reducing banks' leverage reduces the risk and cost of equity but leaves the overall weighted average cost of capital unchanged. We test these two predictions using U.S. data. We confirm that the equity of better-capitalized banks has lower systematic risk (beta) and lower idiosyncratic risk. However, over the last 40 years, lower risk banks have higher stock returns on a risk-adjusted or even a raw basis, consistent with a stock market anomaly previously documented in other samples. The size of the low risk anomaly within banks suggests that the cost of capital effects of capital requirements may be considerable. Assuming competitive lending markets, banks' low asset betas implied an average risk premium of only 40 basis points above Treasury yields in our sample period; a calibration suggests that a ten percentage-point increase in Tier 1 capital to risk-weighted assets may have increased this to between 100 and 130 basis points per year. In summary, the low risk anomaly in the stock market produces a potentially significant cost of capital requirements.
Keywords: capital requirements; cost of capital; low risk anomaly; bank regulation
JEL Codes: G02; G14; G21; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| higher capital ratios (G32) | lower equity betas (C46) |
| lower equity betas (C46) | lower cost of equity (G12) |
| higher capital ratios (G32) | lower cost of equity (G12) |
| 10 percentage point increase in tier 1 capital (G28) | raise weighted average cost of capital by 100 to 130 basis points (G31) |
| increased capital requirements (G28) | increased lending rates (G21) |
| lower beta stocks (C46) | higher returns (G12) |
| low-beta banks (G21) | outperform high-beta banks (G21) |