Do Strict Capital Requirements Raise the Cost of Capital? Bank Regulation and the Low Risk Anomaly


Speaker


Abstract

Traditional capital structure theory in frictionless and efficient markets predicts that reducing banks’ leverage reduces the risk and cost of equity but does not change the overall weighted average cost of capital (and thus the rates for borrowers). We test these two predictions. We confirm that the equity of better-capitalized banks has lower beta and idiosyncratic risk. However, over the last 40 years, lower risk banks have higher stock returns on a risk-adjusted or even a raw basis, consistent with a stock market anomaly previously documented in other samples. The size of the low risk anomaly within banks suggests that the cost of capital effects of capital requirements is large enough to be relevant to policy discussions. A calibration assuming competitive lending markets suggests that a binding ten percentage-point increase in Tier 1 capital to risk-weighted assets more than doubles banks’ average risk premium over Treasury yields, from 40 to between 100 and 130 basis points per year, and presumably raises rates for borrowers to a similar extent.

This event is an Erasmus Finance Seminar. The Erasmus Finance Seminar series brings prominent researchers in Finance from all over the world to Rotterdam.