Are Banks Special?

Michel Crouhy, Dan Galai*

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

2 Scopus citations

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.

Original languageEnglish
Article number1840004
JournalQuarterly Journal of Finance
Volume8
Issue number4
DOIs
StatePublished - 1 Dec 2018

Bibliographical note

Publisher Copyright:
© 2018 World Scientific Publishing Company.

Keywords

  • accounting vs. market value of equity capital
  • bank regulation
  • capital structure
  • CCA (Contingent Claim Approach)
  • cost of capital
  • deposit insurance
  • GFC (Great Financial Crisis)
  • leverage
  • M&M (Modigliani-Miller) Propositions
  • pricing risk

Fingerprint

Dive into the research topics of 'Are Banks Special?'. Together they form a unique fingerprint.

Cite this