Trust in Modigliani-Miller theorem is misguided, say former BCBS members

 

Regulators are wrong to believe changing the capital structure of banks will not affect their value as stated by the Modigliani-Miller theorem, say Urs Birchler and Patricia Jackson

Author: Central Banking Newsdesk

Source: Central Banking | 25 Sep 2012

 

 

The drive by regulators around the globe to make banks hold more and better quality equity capital is causing unexpected patterns of behaviour, particularly that of shareholders calling for bank deleveraging rather than supporting new equity placements.

The fundamental problem is not whether or not equity is more expensive than unsecured bonds, but whether or not banks will easily be able to increase either

The reason for this behaviour is due to the Modigliani-Miller theorem not holding true in the real world, according to a paperpublished Urs Birchler, professor of banking at the University of Zurich and a former director at the Swiss National Bank, and Patricia Jackson, head of financial regulation for Europe, the Middle East, India and Africa at Ernst & Young and former head of the Bank of England's financial industry and regulation, in the latest edition of the Central Banking Journal.

The Modigliani-Miller theorem asserts that firms' assets generate cashflows and changing the way those cashflows are paid out to shareholders and debtholders that fund the firm does not change value of the firm. However, the theorem is often cited as the capital structure ‘irrelevance principle' whereby a firm's structure does not affect the value of the firm.

Senior central banker and regulators, such as the Bank of England governor Mervyn King, cite the Modigliani-Miller theorem for their belief that changes in bank capital rules will not adversely hurt banking operations. "The cost of capital overall is much less sensitive to changes in the amount of debt in a bank's balance sheet than many bankers claim," King said in 2010.

However, Birchler and Jackson, both former members of the Basel Committee on Banking Supervision, found that while the Modigliani-Miller theorem holds for banks, "the (stronger) capital structure irrelevance principle is contravened by the ability of banks to raise insured (or implicitly guarantees) deposits, which are risk-insensitive – debt finance thus is subsidised". "The irrelevance principle, as Modigliani and Miller made clear, only holds true under a number of assumptions. These are: efficient markets, the absence of taxes, bankruptcy costs and asymmetric information (including agency costs," the authors said.

Birchler and Jackson added that current research indicates the capital structure irrelevance proposition partially hold, but no research in this area addresses the adjustment period regarding how long will it take after an imposed capital increase to reach a steady state. The research also does not "consider whether there are issues related to the aftermath of the banking crisis, which will make the adjustment more difficult", Birchler and Jackson said.

"The fundamental problem is not whether or not equity is more expensive than unsecured bonds, but whether or not banks will easily be able to increase either," Birchler and Jackson said. "The determination by governments to reprivatise bank risk, therefore, is likely to clash with shareholder reluctance to raise capital levels. Given that equity to risk-weighted assets has to be increased substantially under Basel III, the result could be that shareholders may prefer to see deleveraging through a reduction in lending."

The Modigliani-Miller theorem was developed by Nobel-prize winning economists Franco Modigliani and Merton Miller in the 1950s.