Alan Greenspan’s paper on the financial crisis calls for regulatory capital requirements on banks to be increased but also warns that there are limits to how much they can be increased. In his words: “Without adequate leverage, markets do not provide a rate of return on financial assets high enough to attract capital to that activity. Yet at too great a degree of leverage, bank solvency is at risk.” Greg Mankiw wonders whether the above assertion does not violate the Modigliani-Miller Theorem and is right to do so. Although Greenspan’s conclusion is correct, his argument is incomplete and misses out on the key reason why leverage matters for banks – the implicit and explicit creditor guarantee.
I explained the impact of creditor protection on banks’ optimal leverage in my first note. The conclusions which I summarised in a more concise form in this note are as follows: Even a small probability of a partial bailout will reduce the rate of return demanded by bank creditors and this reduction constitutes an increase in firm value. In a simple Modigliani-Miller world, the optimal leverage for a bank is therefore infinite. Even without invoking Modigliani-Miller, the argument for this is intuitive. If each incremental unit of debt is issued at less than its true economic cost due to deposit insurance or the TBTF doctrine, it “increases the size of the pie” and adds to firm value. In reality of course, there are many limits to leverage, the most important being regulatory capital requirements.
Indeed, the above is the main reason why we have any regulatory capital requirements at all. In the absence of regulation, a bank with blanket creditor protection will likely choose to operate with minimal equity capital especially when it has negligible franchise value or is insolvent. This is exactly what happened during the S&L crisis when bankrupt S&Ls with negligible franchise value bet the farm on the back of a capital structure almost completely funded by insured deposits.