On the non-neutrality of the financing policy and the capital regulation of banking firms
Abstract
Purpose
The paper aims to investigate whether the value of banks is affected by their financing policies. Higher capital requirements have been invoked by exploiting a renewed edition of the Modigliani–Miller (M&M) theorem. This paper shows the limits of this claim by highlighting that the general statement that “bank equity is not expensive” can be misleading. The authors argue that market prices should play an important role in bank supervision. Expectations of future profits in prices supply timely information on the viability of a bank.
Design/methodology/approach
The authors use the Merton model to show the inapplicability of M&M theorem to banks. The long-run viability of a bank is analyzed with a dividend discount model which allows to compare a bank’s long-term profitability with its overall cost of capital implicit in market prices.
Findings
The authors show that the M&M framework cannot be applied to banks neither ex-ante nor ex-post. Ex-ante the authors focus on government guarantees, ex-post they emphasize the risk-shifting phenomena that may increase the overall risk of the bank. The authors show that a bank’s stability cannot be achieved if the market expectations of its future profits stay below the cost of funding.
Research limitations/implications
The authors use simple analytical models. In a future study, some key peculiarities of banks, such as the monetary nature of deposits, should be analytically modelled.
Practical implications
The paper contributes to the debate on capital regulation on the level of capital requirements and the instruments to assess the viability/stability of banks.
Originality/value
This paper uses simple models to assess analytically the key issues in the debate on banks’ capital regulation.
Keywords
Acknowledgements
This note is an update of a working paper titled “Cost of equity, enterprise value and capital regulation of banking firms”. The authors would like to thank, without implicating, Carlo Andrea Bollino, Pietro Alessandrini, Gaia Barone and all the participants at seminars in Banca d’Italia (February 2013) and World Finance Conference 2014 (July 2014) for very helpful discussion and criticism of the paper. Opinions and ideas expressed in this paper are those of the authors’ and do not imply any responsibility for their institutions.
Citation
Masera, R. and Mazzoni, G. (2016), "On the non-neutrality of the financing policy and the capital regulation of banking firms", Studies in Economics and Finance, Vol. 33 No. 4, pp. 466-487. https://doi.org/10.1108/SEF-09-2014-0179
Publisher
:Emerald Group Publishing Limited
Copyright © 2016, Emerald Group Publishing Limited