Are Banks Special?

Michel Crouhy () and Dan Galai
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Michel Crouhy: Head of Research & Development, Natixis, Paris, France
Dan Galai: The School of Business Administration, The Hebrew University, Jerusalem, Israel3The Sarnat School of Management, Or Yehuda, Israel

Quarterly Journal of Finance (QJF), 2018, vol. 08, issue 04, 1-19

Abstract: This paper addresses the following question: Are banks special firms that can achieve their goals only with high leverage, above and beyond what is considered acceptable for industrial corporations?This question is related to the issue of the cost of capital and how it is affected by leverage. If we accept the Modigliani–Miller (M&M) theorem (1958), then the capital structure is irrelevant for both the cost of capital and the value of the bank. Specifically, the M&M hypothesis argues that higher levels of equity capital reduce bank leverage and risk, leading to an offsetting decline in banks’ cost of equity capital. Hence, we ask the question whether banks are special firms such that M&M theorem does not apply to banks.We show that M&M propositions cannot be applied for banks primarily because of explicit guarantees and subsidies that provide incentives for increasing leverage. Then, some of the risk faced by the bank is transferred at no cost to the providers of these guarantees and subsidies, giving banks the incentive to increase leverage as much as they can. We show that under perfect market conditions, when risk is fairly priced, this opportunity vanishes.

Keywords: CCA (Contingent Claim Approach); M&M (Modigliani–Miller) Propositions; capital structure; leverage; deposit insurance; cost of capital; bank regulation; pricing risk; GFC (Great Financial Crisis); accounting vs. market value of equity capital (search for similar items in EconPapers)
Date: 2018
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Citations: View citations in EconPapers (1)

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DOI: 10.1142/S2010139218400049

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