In the case of banks, the Modigliani-Miller Theorem is absolutely inapplicable

James Kwak of the Baseline Scenario, in a post titled: “More Misinformation about Banking Regulation” while discussing the effects of increased capital requirements writes:

“The Modigliani-Miller Theorem…says that a firm’s capital structure — the amount of equity it has relative to debt — doesn’t matter: in the case of the hypothetical bank, if you increase equity and reduce debt, after the reduced debt payments, there is just enough cash left over to compensate the larger number of shareholders at the lower rate that they are now willing to accept.

Now, the assumptions of Modigliani-Miller don’t hold in the real world, but the main reason they don’t hold is the tax subsidy for debt…

Since the cost of capital doesn’t change with capital requirements (except, again, because of the tax subsidy for debt), the amount of bank lending doesn’t change either.” 

Oops… that is in itself some misinformation! 

For banks, besides tax considerations, the Modigliani-Miller Theorem is absolutely inapplicable; since it does not consider the value of the support society (taxpayers) explicitly or implicitly give the holders of bank debt. If a bank has 100% equity then all risk falls on the shareholder and the societal support is 0. If a bank has 5% equity and 95% debt then society contributes a lot to the party.

Frankly, like in Europe, where some banks were leveraged about 50 to 1, and rates on bank deposits are still low, who on earth can one even dream to bring the Modigliani-Miller Theorem into the analysis?

And the fluctuating societal support, is one of the main reasons behind the argument I have been making for over a decade, about how credit-risk adjusted capital requirements for banks distort the allocation of credit. Regulators are telling the banks: If you lend to what is perceived as safe, like to the AAArisktocracy, then you are allowed to hold less capital, meaning leveraging more, meaning you will receive more societal (taxpayer) backing, than if you lend to a risky SME. 

And so of course, if you increase capital requirements which reduces the leverage, banks will get less taxpayer support… ergo lend less and at higher interest costs. Would that be bad for the economy? Of course it would keep billions out of the economy (it already happens) especially while business models are adjusted and bank capital increased. But that austerity J (less societal support spending) though it would hurt would not necessarily be bad… what is really bad for the economy are the different capital requirements for different assets… since that stops bank credit from being allocated efficiently.

Take away all deposit guarantees and all bailout assistance, and then the Modigliani-Miller Theorem, subject to tax considerations would be more applicable to banks.