The Cost of Equity Capital for Banks

A NEW RESEARCH PAPER BY ELENA CARLETTI, JOINT WITH FRANKLIN ALLEN AND ROBERT MARQUEZ, SHOWS THAT EQUITY CAPITAL IS A COSTLY FORM OF FINANCE FOR BANKS RELATIVE TO DEPOSITS. THIS IMPLIES THAT CAPITAL REGULATION AND DEPOSITS INSURANCE CAN POTENTIALLY AFFECT THE OPTIMAL CAPITAL STRUCTURE

The issue of capital has been fundamental for banks over the last few years, a period marked by the worst financial crisis since the Great Depression. Bank capital has been under severe stress as a result of massive write-downs of bad assets and losses on real-estate-related lending. Many banks have sought to rebuild capital by raising money in the private markets. How such financing can be done optimally becomes therefore of first order importance.

Common wisdom posits that equity capital is a “costly” way of financing for banks relative to deposits. In fact, the latter represents an important and increasing fraction of the funding structure for banks and the global economy as a whole. However, how to optimally choose equity vs. deposits, and how this choice is affected by existing regulation remains an open question. In their recent article forthcoming in the Journal of Financial Economics (doi:10.1016/j.jfineco.2014.11.003), Deposits and Bank Capital Structure, Elena Carletti (Department of Finance), Franklin Allen (Imperial College and University of Pennsylvania), and Robert Marquez (University of California, Davis) try to provide a plausible answer to such key questions.
 
Several articles in the literature of theory of bank funding have shown that deposits are often the optimal form of funding for banks. The underlying idea is that deposits are simply another form of debt which doesn’t necessarily make them preferable especially in cases of bankruptcy. However, there is considerable evidence that the market for deposits is significantly segmented from other markets. As a matter of fact, while most people in developed countries have bank accounts, with the exception of the U.S. and a few other countries, household finance literature documents that relatively few people own stocks, bonds or other types of financial assets either directly or indirectly. Such differentiation makes the market for deposits inherently different from others.
 
In their article, the authors take steps from the debt-specific interpretation of deposits and build a model to show that capital structure is relevant for bank value and there is a unique optimal capital structure, which involves banks holding a positive level of equity capital as a way to reduce bankruptcy costs. The optimal amount of bank equity capital is counter-cyclical as it decreases (weakly) with the return of the bank’s assets. Also, the authors show that equity providers do not invest in the risky asset directly and that equity capital is "costly" relative to deposits.
 
Interestingly, the authors show that when a regulatory intervention in the form of deposits insurance is in place, banks no longer have any incentive to hold equity, instead choosing to finance themselves entirely with deposits. Indeed, when deposits are insured, equity capital does not help reduce bankruptcy costs therefore banks will prefer not to raise any capital. This gives rise to a role for capital regulation. By requiring banks to hold capital, a regulator reduces bankruptcy costs that would otherwise be borne by the deposit insurance fund (and ultimately market participants through some form of lump sum taxation). As such, the authors show that a form of deposit insurance coupled with capital regulation can always achieve a higher level of social welfare, and therefore be optimal as a whole.

by Daniele Bianchi