Basel III Capital Requirements

Impact of Higher Capital Requirements on Bank Funding Costs

Maurits J. H. Kruithof Masters Thesis Business Economics, Finance Track

Date: Student Number: Supervisor: Second Examiner:

March 14, 2013 5603404 Professor Arnoud W. A. Boot Dr. Jeroen E. Ligterink

University of Amsterdam, Faculty of Economics and Business

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Basel III Capital Requirements

Impact of Higher Capital Requirements on Bank Funding Costs Abstract This thesis analyzes the impact of higher capital requirements on bank funding costs. Often is claimed that capital is an expensive form of funding. An extensive literature review of theoretical insights points out that this is not necessarily the case. The foundation of capital structure research is the Modigliani-Miller theorem. The question is whether this theorem holds in practice and is applicable to banks. It proves to be a useful theorem to identify relevant frictions and distortive policies. This thesis scrutinizes the public policies that favor debt financing over equity financing, because the corporate tax system and implicit government guarantees create a significant lower cost of debt funding. The Basel III capital requirements should therefore be complemented with tax policy reforms and recapitalization of the banking system with the use of a contingent capital (CoCo) requirement. JEL classifications: G21, G28, G32, G38, H25 Keywords: Banking Regulation, Basel III, Capital Requirements, Capital Structure, Funding Costs, Government Guarantee, Lending Spread, Leverage, Modigliani-Miller Theorem, Tax Shield.

Table of Contents 1. PART I 2. 2.1 2.2 2.3

2.3.1 2.3.2

Introduction. 7 Theory and Empirics Higher Capital Requirements: Theoretical Insights. 10 Modigliani and Miller (1958).. 10 Modigliani-Miller Theorem versus CAPM. 12 Having More Equity Capital: Steady State. 15 Cost of Capital Fallacy. 15 The Role of Subsidies on Debt in New Equilibrium 16 Raising More Equity Capital: Transition Phase 17 Information Asymmetry. 17 Debt Overhang 18 Conclusion. 20 Empirical Studies on Higher Capital Requirements.. 21 Kashyap, Stein and Hanson (2010). 21 King (2010). 22 Angelini et al. (2011).. 24 Cosimano and Hakura (2011).. 27 Santos and Elliott (2012). 29 Conclusion. 30 Tax Shield, Government Guarantee and Policy Reforms Tax Shield on Debt 32 The Methodology of Debt Tax Shield Calculation. 32 The Size of the Dutch Bank Tax Shield. 33 The Future of the Tax Shield. 37 Government Guarantees and Recapitalization.. 39 Impact and Consequences of Government Guarantees. 39 The Size of the Dutch Government Guarantee.. 40 Recapitalization of the Banking System.. 44 Summary and Conclusion. 46

2.4
2.4.1 2.4.2

2.5 3. 3.1 3.2 3.3 3.4 3.5 3.6 PART II 4. 4.1 4.2 4.3 5. 5.1 5.2 5.3 6.

List of Abbreviations. 48 Bibliography 49 Other References, Sources and Data.. 53 Appendices.. 54

List of boxes, figures and tables Box 2.1: Figure Figure Figure Figure Figure Figure Figure Figure Figure Table Table Table Table Table 1.1: 2.1: 3.1: 4.1: 4.2: 4.3: 4.4: 4.5: 5.1: Roles of Capital. 10 Process Display of the Statement. 7 Alternative Responses to Increased Capital Requirements. 19 Alternative Responses to Increased Capital Requirements. 26 Leverage (Equity Multipliers) of Three Largest Dutch Banks. 34 Key Interest Rates. 35 Tax Shield on Debt (in EUR millions). 36 Tax Shield as a Percentage of Total Assets. 36 Fee Income as a Percentage of Total Interest and Fee Income.. 37 Notches Between Stand-Alone and Supported Credit Ratings. 41 Profit and Loss Account, Tax Shield 32 Corporate Tax Rate in the Netherlands 33 Leverage (Equity Multipliers) of Three Largest Dutch Banks. 34 Implicit Subsidy High (In Millions) 1999-2012.. 42 Implicit Subsidy Low (In Millions) 1999-2012 42

4.1: 4.2: 4.3: 5.1: 5.2:

Appendices 1. 2. 3. 4. 5. 6. 7. Data Leverage Calculation 54 Key Interest Rates.. 55 Data Tax Shield. 56 Net Interest and Fee Income. 57 Data and Calculations Implicit Government Guarantee 58 Capital Ratios Graphs 62 Bank Lending Spreads Graph. 63

Preface After a difficult start, where Ive spent several months reading all sorts of papers that were very interesting but totally not relevant, I finally got the spirit during my first extensive meeting with professor Boot in his office. Im very thankful for his support, advice and time he spent with me on my thesis. I also think that this is the right place to express my gratitude to him for all he has done to help Room for Discussion achieve success. It happens rarely these days that a mentor-student relationship is possible when so many students are pursuing their ambitions. I was privileged to have such a great mentor. I also want to thank my parents for their ongoing support and interest during my studies and work for Room for Discussion. Theyve helped me creating the circumstances in which I could do all the things I needed to do, for that Im very grateful. After all the interviews and debates I did for Room for Discussion, I certainly knew that my thesis had to be about banks and the financial sector. During one of my preparations for a debate I found a speech by Thomas Huertas, which was written before the collapse of Lehman Brothers. It contained the following quote1: Capital is the cornerstone of banking. Capital is the foundation on which banks take risks and achieve rewards, and capital is ultimately what protects deposits. If capital really is the cornerstone of banking, why were banks so poorly capitalized that the banking crisis of 2007-2009 could happen? Well, Ive tried to find an answer and that ultimately resulted in this Masters thesis.

Maurits Kruithof Amsterdam, March 2013

Derived from a speech by Thomas Huertas, FSA United Kingdom, June 26 2008, via www.fsa.gov.uk. * I thank my friends Richard Evers and Gerben Smit for their useful comments and suggestions. I also thank the banks, accountancy and consultancy firms with whom Ive had several informal meetings for their time, advices, comments, criticism and willingness to spar with me.

th

1.

Introduction

The recent financial crisis of 2007-2009 shows that the ability of the banking sector to deal with major shocks must be strengthened. The assets that are held by the banking sector are too risky or high priced compared to the amount of capital on the liability side of the balance sheet. The sector is not capable to absorb losses on their own positions, portfolios and loans provided to companies and households. In 2008 and 2009 governments across the world had to recapitalize banks and guarantee bank debt. To prevent recurrence of such problems in the long run the Basel Committee presents reforms to strengthen global capital and liquidity rules, henceforth Basel III (BCBS, 2010a). This should improve the resilience of individual institutions, but also contribute to greater stability of the financial system as a whole. The measures of Basel III intervene in the capital structure of banks. The banking sector has to acquire more capital and of higher quality. Banks balance sheets and capital structures will be different after the implementation of Basel III. Many bankers argue that equity capital is expensive and higher capital requirements increase the total cost of funding and the price of a bank loan. Therefore, this thesis examines the following statement: equity capital is the most expensive form of funding compared to debt and depositors money, therefore raising capital requirements increases the total costs of bank funding (figure 1.1 and equation (1)).

Higher capital requirements

Higher cost of equity funding

Higher total cost of funding

Figure 1.1: Process Display of the Statement

!"#$%&'% < !"#$!!!"#$ < !"#$ !"#$ !"#$ < !"#$%&

(1)2

This master thesis explains the relationship between equity capital held by a bank and total costs of bank funding. It tries to set out what impact higher capital requirements, such as the Basel Committees (BCBS, 2010a) capital requirements, have on the banks funding costs of debt and equity and the price of a bank loan. The research question of

Source: King (2010), is the (required) rate of return.

this thesis is: What impact have higher capital requirements on the cost of equity capital and total funding costs? This study reviews important theoretical literature that is available on the impact of higher capital requirements. It also analyzes recent papers that empirically tested the effects of higher capital requirements on total funding costs and prices of bank loans. The assumptions of these empirical studies are compared to the fundamental and theoretical insights, including those from Admati et al.s (2011) key paper. Analyzing higher capital requirements demands a clear distinction between having more equity capital (steady state) and raising more equity capital (transition phase). The dynamics of a steady state and transition phase analysis are rather different. Based on the Modigliani-Miller capital structure theory (1958), Admati et al. (2011) state that bank capital is not expensive and that many arguments are fallacious (steady state). Though, not a few other authors question the applicability of the Modigliani-Miller theorem on banking. Banks have a certain special role, which is to provide liquidity to the economy and debt is the instrument that banks need to fulfill this role. However, it turns out that public policy creates distortions in the funding costs of debt and equity, mainly due to fiscal incentives and government guarantees. The high leverage ratio of the financial sector is partly explained by these policies that subsidize debt. Higher capital requirements mean that banks can make less use of these implicit subsidies. These distortions can be resolved, since they are part of public policy. This thesis is relevant to financial policy makers, people working in the financial sector and those engaged in scientific research into capital regulation. It should lead to a better understanding and awareness of the importance of correct and sufficient capital regulation in relationship with capital structure. It provides a discussion of state of art theories and concepts written in fundamental papers about capital regulation, capital structures and bank lending. This thesis explains that public policy favors debt financing and gives proposals of how policies on taxation and government guarantees can be reformed, or at least which direction new policies should have to reduce the incentives for debt financing. It also provides a notion of recapitalization, which reduces the government guarantee and debt overhang problem. The system has to be robust and able to absorb losses, while less dependent on government guarantees. This thesis proceeds as follows. The first part of this thesis focuses on theoretical and empirical studies of higher capital requirements and funding costs. Starting with chapter two, it discusses the theoretical insights related to higher capital requirements, the difference between raising and having more equity capital and what kind of impact this

has on banks funding costs. Chapter three compares assumptions and results of empirical studies with the theoretical insights of chapter two. The result of this analysis emerges two main distortive policies in the discussion of higher capital requirements, namely corporate tax rules and governments guarantees that implicitly favor debt financing. These two distortions will be at the center of the second part of this thesis, respectively chapters four and five. Chapter four elaborates the tax shield methodology, provides a calculation of the Dutch size of the tax shield and proposes tax policy reforms. Chapter five sets forth the implicit government guarantee, estimates the size of the Dutch guarantee and proposes efficient recapitalization in relationship with government guarantees. This thesis ends with a summary and conclusion in chapter six.

PART I 2.

Theory and Empirics

Higher Capital Requirements: Theoretical Insights

This chapter discusses theoretical concepts and insights related to the capital structure of banks, banks funding costs and higher capital requirements. The basic theory of capital structure composed by Modigliani and Miller (1958) is the starting point of this chapter. Many arguments that are put forward by Admati, DeMarzo, Hellwig and Pfleiderer (2011) are based on this theory of corporate finance. Admati et al. (2011) explain why bank equity is not expensive and refute many fallacious, irrelevant and/or very weak arguments. But the academic literature is ambivalent in thinking about the Modigliani-Miller theorem and its applicability to banks. This chapter also explains important distinctions between raising more equity capital (transition phase) and having more equity capital (steady state). The dynamics of raising and having more equity capital are quite different. Raising more equity capital implies debt overhang problems and creates information asymmetry problems. Having a higher equity capital ratio in a new, steady state, equilibrium affects e.g. the benefits of the tax shield and implicit or explicit government guarantees. This chapter ends with a brief summary and conclusion. 2.1 Modigliani and Miller (1958) Modigliani and Miller (1958), who wrote a fundamental paper about capital structure, state that under certain assumptions a firms capital structure is irrelevant for I) its value and II) weighted average cost of capital (WACC). These are known as the Modigliani and Miller Propositions I and II. The four assumptions made in the frictionless Modigliani and Miller world are severe; they include no information asymmetry, taxes, financial distress costs and transaction costs.
Box 2.1 Roles of Capital Capital is one of the most fundamental concepts in economics. Wherever there is entrepreneurial activity, investments made and clients served, capital plays an essential role in businesses. It provides funding, receives profits and is the only mechanism on the balance sheet to absorb losses. The role of capital can roughly been split into three main characteristics3: 1) as a technical instrument on balance sheets, 2) as a governance tool and 3) as a systemic buffer. The first role of capital is technical. The amount of capital relative to the amount of debt is crucial in this wide debate on the role of capital. The extent to which capital is risky or costly relies on the leverage of a firm (Modigliani and Miller, 1958) and the riskiness of the assets. The second

Inspired by Modigliani and Miller (1958, p. 261) who viewed their main question what is the cost of capital? through three perspectives, the one of the corporate finance specialist (technical), the manager (governance) and macroeconomist (systemic level).

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important and fundamental function of capital is that it monitors the management and distributes risk among its shareholders. Shareholders are more or less the owners of the company and they use their voting rights to control or influence management decisions. The agency theory explains the moral hazard and adverse selection problems (Jensen, 1986). Third, capital provides as a buffer for the system as a whole to absorb losses. The first and second roles of capital are important for individual firms, while the systemic role of capital matters the economy as a whole. Frequently, the systemic role of capital is wrongly separated from the individual interests of a firm (Admati et al., 2011). Some argue that capital is too expensive and that cheaper debt finance is preferable (Gorton, 2010). However, this may not be the case if welfare costs of high leverage ratios are included (Admati et al., 2011). Berger (1995) states that regulators use capital requirements to create safety nets and to protect the economy from negative externalities. In this way, the systemic role of capital is taken into account for individual financial institutions. A second misunderstanding that is important to mention here is that capital is not something to keep idle or that must be set aside (Admati et al., 2011). Cochrane (2013) states: capital is a source of money, not a use of money. There is a difference between capital requirements and liquidity or reserve requirements. Capital requirements prescribe banks how to fund themselves with debt or equity (leverage ratio), while liquidity or reserve requirements relate to the type of assets and asset mix banks must hold (Admati et al., 2011). Capital requirements address the right-hand side of the balance sheet and liquidity or reserve requirements the left-hand side. However, there is a link between capital requirements and assets, because of the Risk Weighted Assets (RWA) rule that is included in all Basel Accords.4 Nevertheless, once a bank meets reserve or liquidity requirements, all capital can be used for new loans and investments.5

An important proposition to discuss is whether the Modigliani-Miller theorem is applicable to banks, under the same assumptions mentioned above. Bank balance sheets and operations are fundamentally different compared to non-bank firms. For example, banks produce financial debt instruments such as deposits, short-term commercial paper and repurchase agreements to provide liquidity to the economy, while non-bank firms do not fulfill this function. Admati et al. (2011) conclude that, based on the framework of Modigliani and Miller, higher capital requirements have no significant, long-term, negative consequences for the economy that offset the benefits. This only concerns the new equilibrium (steady state), thus after the equity capital is acquired. Miller (1995) states that the Modigliani-Miller theorem is only applicable ex ante, when equity capital ratios can be fully anticipated in an equilibrium (at t=0 or t=1). The theorem is not applicable during the transition phase, the time between t=0 and t=1. The interest rates on debt do not reflect the new equity capital infusion between t=0 and t=1, simply Each asset that a bank holds is risk-adjusted, which means that high risk assets require a higher capital ratio. More about capital and bank lending, see Cebenoyan Strahan (2004) Fabi et al. (2005) Gambacorta, Mistrulli (2004) Inderst, Mueller (2008) Thakor (1996) Elliott (2010a).
5

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because most of the debt is already in place and terms and conditions cannot be renegotiated. However, there is an extensive collection of literature available that discusses the applicability and relevance of the Modigliani-Miller theorem on banking in the steady state (the equilibrium of today at t=0). If the Modigliani-Miller theorem does not hold on banking in its pure form, could increasing capital requirements have significant consequences for banks overall cost of capital and eventually their lending spreads in the new equilibrium (steady state at t=1)? The applicability of the Modigliani-Miller theorem is questioned in a paper by Gorton, Lewellen and Metrick (2011). They argue that bank debt is information-insensitive6 similar to government debt. According to Gorton et al. (2011) and Gorton (2010), bank debt is immune to adverse selection in trading because agents do not want to acquire private information about the current health of the bank, since acquiring or generating information is costly. Gorton et al. (2011) regress the fraction of financial liabilities in the economy against the fraction of government liabilities in the economy and find that government and financial liabilities are viewed as acceptable substitutes by investors. Gorton et al. (2011) argue that bank debt therefore may contain a convenience yield, like government debt. A convenience yield is a yield below what might be expected according to standard fixed income calculations7. In other words, investors in bank debt are willing to accept a lower rate of return due to the implicit or explicit government guarantee. Gorton et al. (2011) use an average convenience yield of 70 basis points. In a world with such implicit government guarantees the Modigliani-Miller theorem no longer holds. Implicit and explicit government guarantees are therefore a distortion in the pricing of banks funding costs. Paragraph 2.3 and chapter five will elaborate on the distortive effects of implicit government guarantees. 2.2 Modigliani-Miller Theorem versus CAPM A widely debated consequence of higher capital requirements is that more equity capital should lower the Return On Equity (ROE). Although many bankers claim that equity capital is expensive and consider the ROE as fixed, basic corporate finance theory shows that these propositions are inconsistent. The ROE increases both by more asset risk and/or more leverage and vice versa. The proposition that more equity capital decreases the ROE can be interpreted on the basis of two theories. First, the Modigliani-Miller theorem state that the distribution of total asset risk among more shareholders lowers

Note from the author: the definition information-insensitive seems a contradictio in terminis, like risk-free is too. 7 For example, the Dutch State has recently issued short-term debt with negative interest rates.

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the ROE, while total funding costs of the bank remain unchanged (proposition II). Admati et al. (2011) rely heavily on this theorem and proposition. Second, the Capital Asset Pricing Model (CAPM) calculates the required rate of return of a security (in this case a bank stock, thus the return on equity) in relation to its risk (!"#$%& ). The risk (!"#$%& ) is dependent on leverage (
! !! !

). The CAPM formula states that the ROE (!"#$%& ) equals the

risk-free rate (! ) plus a risk premium (! ) multiplied by the risk factor (!"#$%& ): !"#$%& = ! + !"#$%& ! (2)

This model is independent of the Modigliani-Miller theorem and is using different assumptions. But, since both the Modigliani-Miller theorem and CAPM calculate the ROE, Gorton et al. (2011) and Miles, Yang, Marcheggiano (2012) find it useful to examine their relationship. Does the Modigliani-Miller theorem holds simultaneously with CAPM? Gorton et al. (2011) state that if a bank satisfies the minimum capital requirements it can produce information-insensitive debt with a convenience yield. Banks that do not satisfy the minimum capital requirements are considered insolvent: their debt will become information-sensitive. The existence of a convenience yield on debt breaks the basic corporate finance theory on capital structure, risk and return. Holding asset risk and return on assets unchanged, existing shareholders benefit from cheaper debt at the expense of debt holders (and at the expense of taxpayers when a bail-out is needed). The implicit government guarantee enables shareholders to receive a higher return. If banks would follow the corporate finance theory, the advantage of the convenience yield must result in lower interest rates charged on loans. Because banks can obtain cheaper debt, they are able to offer loans with lower interest rates. This would imply that the relationship between the Modigliani-Miller theorem and CAPM does not hold. According to Gorton et al. (2011), either one of the following two statements can be true: I. The ROE of banks exceeds their cost of capital under the CAPM. In this case, the Modigliani-Miller theorem still holds, but CAPM no longer holds (= higher return on equity with no significant change of risk). II. Because of the existence of a convenience yield, banks can lower their return on assets (interest rates charged on loans), leaving the returns on equity and debt unchanged. Now, the CAPM holds, but Modigliani-Miller Proposition II no longer holds.8 Gorton et al. (2011) regress bank equity returns against the market portfolio to test whether statement I is true and banks earn a significant higher equity return given their

The required return on assets is independent of the firms capital structure.

13

level of risk. They find no abnormal equity return relative to the CAPM, which means statement II is most likely the case and statement I is not true (Gorton et al., 2011). Because the counterfactual of statement II is not directly observable, Gorton et al. (2011) cannot test this statement. However, they assume that the convenience yield influences the interest rate that banks charge on loans. Banks are driven by competition and will therefore lower their interest rates charged on loans to gain as much clients as possible. Gorton et al. (2011) argue that non-bank firms dont issue similar debt with a convenience yield, because these firms are able to obtain the same gain as a borrower by taking out a bank loan with a lower interest rate. Miles et al. (2012) state that the Modigliani-Miller theorem is unlikely to hold exactly and use the theorem to assess its relevance for measuring the social costs of more equity financed lending by banks. They refer to key questions such as how the probability of crisis falls when banks hold more capital and to what extent the ROE lowers when banks hold more capital and reduce the risk of that capital. Miles et al. (2012) mention the tax and guarantee distortions as important factors that influence financial structure. As mentioned earlier, these distortions ensure that Modigliani-Miller theorem does not hold completely. Miles et al. (2012) use data on UK banks to test this empirically (chapter 3). Similar to Gorton et al. (2011), Miles et al. (2012) use the CAPM to test if bank leverage and risk/return are correlated. The risk of bank assets (!""#$" ) is distributed among debt and equity holders. Therefore, !""#$" can be written as follows: !""#$" =
! ! !! ! ! !!

+ !"#$

(3)

(D=debt, E=equity and !"#$ =risk of debt)

Assuming that debt is riskless (!"#$ = 0), this equation implies: !"#$%& =
! !! !

!""#$

(4)

Equation (4) shows the similarity of the CAPM and Modigliani-Miller theorem (Miles et al., 2012), namely a linear relationship between risk and leverage. Under the assumption of riskless debt, which is more or less the same as a convenience yield, the ROE depends on leverage. More equity capital results in a decrease of risk and return on equity. Miles et al. (2012) regress equation (4) to test the linear relationship between risk and leverage. Will the CAPM and Modigliani-Miller theorem hold if banks halve their leverage? This implies that equity risk (!"#$%& ) is reduced by 50%. Their results show that the relationship between the Modigliani-Miller theorem and the CAPM does not hold.9 The

Gorton et al. (2011) draw the same conclusion.

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equity risk is not linearly related to leverage because externalities influence the return on equity.10 However, they use the test results (the coefficients that Miles et al. (2012) found of the CAPM formula !"#$%& = ! + ( + leverage)! ) to estimate the weighted average cost of capital (WACC) assuming that the cost of debt is fixed (risk-free rate) while leverage halves. As mentioned earlier, the second proposition of the ModiglianiMiller theorem states that the WACC is irrelevant to the capital structure, therefore the
WACC

should not change. Miles et al. (2012) find an increase of the WACC and estimate

that the rise in WACC is only about 55% of what it would be in the absence of the Modigliani-Miller theorem. In other words, there is a Modigliani-Miller effect and the theorem holds for approximately 45% of the full extent. 2.3 Having More Equity Capital: Steady State As the previous paragraphs have shown, the theoretical consequences of higher capital requirements are ambiguous. This paragraph discusses the dynamics of having more equity capital on the balance sheet in a new steady state. How can poorly capitalized banks of today be compared with banks that have a low financial leverage in the new equilibrium when all banks are better capitalized? Important to mention here is that, ex ante, the new equilibrium is hard to predict. Today it is unknown how banks assets or liabilities must be priced in the future. However, could bank capital be an attractive and safe asset class with lower required returns on equity in the new equilibrium?
2.3.1 Cost of Capital Fallacy

The cost of capital fallacy, namely that equity capital is expensive and the return on equity is fixed at a high level, creates a vicious circle. Once a bank has a capital surplus, i.e. any available equity capital above the minimum capital requirement, it tends to economize on capital to increase ROE by engaging in certain activities.11 According to Boot (2013), putting capital to use increases the cost of this capital and may not create value at all. Boot (2013) states that shareholders and other market participants foresee that banks will economize on capital and thus raise their required return on equity. This confirms the belief of banks that equity capital is expensive and that the best response to higher capital requirements is to increase risk on the short-term to realize the required return in the future. Stating that the cost of capital is also expensive in a new equilibrium and that the ROE will be (or must be) fixed in a new equilibrium is fundamentally flawed and misleading, since they do not adjust for risk (Admati et al., 2011). As a caveat, this belief of banks suggests that the new equilibrium consists of

10 11

E.g. corporate tax system, government guarantees, capital regulation and market sentiment. E.g. proprietary trading.

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many more risky assets and activities, which would be the opposite of what higher capital requirements are meant for. Despite of this self-fulfilling belief (or vicious circle), Admati et al. (2011) advocate a banking system with more equity capital. They argue that if the asset risk remains constant, i.e. no significant change on the left side of the balance sheet, an increase in capital requirements lowers the ROE due to less leverage. Note that this applies to the new equilibrium (steady state at t=1). By assuming that asset risk remains constant, Admati et al.s (2011) statement is correct: more equity capital distributes risk. Substantial more equity capital reduces the total per unit risk that is borne by the equity holder, which should result in lower required rates of return. Thus, holding a bank share could be an attractive and safe asset class in the new equilibrium when all banks have more equity capital on their balance sheets and asset risk remains constant.
2.3.2 The Role of Subsidies on Debt in New Equilibrium

The impact of having more equity capital in a new equilibrium is that todays subsidies on debt can be less used in the future. On the one hand, more equity capital distributes risk and lowers the required returns on equity. On the other hand, the implicit government guarantee and tax shield play a smaller role because there is less debt on the balance sheet. This could increase the cost of debt. As mentioned earlier, Gorton et al.s (2011) analysis indicates that when banks have less information-insensitive debt on their balance sheet, the benefit from the convenience yield decreases in the new equilibrium. This also applies to the benefits of the tax shield. The corporate tax system gives a fiscal incentive to finance with debt, because interest payments on debt are tax deductible. When there is less debt on the balance sheet, this fiscal advantage of debt disappears. These reductions of debt-financing advantages increase the total cost of funding, which according to Gorton et al. (2011) results in higher prices for a bank loan. Chapters four and five elaborate the tax shield and implicit government guarantees in more detail and propose some reforms that can be applicable to the new equilibrium and transition phase. Following the theory of Admati et al. (2011), Gorton et al.s (2011) assumptions suffer from a neglect of external costs and misaligned incentives. Gorton et al. (2011) and Gorton (2010) argue that banks produce debt, which distinguishes banks from other companies and makes them special. They also state that the economy needs debt and it is socially desirable that banks produce liquid securities, e.g. securitization of individual mortgages or short-term commercial paper. Although debt is a useful instrument for the

16

economy, this observation does not imply that banks should be highly leveraged. Admati et al. (2011) state that investors do not always need those liquid securities in the form of short-term debt. Bank capital can be a safe and attractive asset class (in a new equilibrium) for long-term investors that are now holding long-term and senior debt. Admati et al. (2011) argue that the attractiveness of short-term debt is enhanced when banks are better capitalized, while investors with longer time horizons hold more equity capital. Given the huge costs of the systems breakdown in the 2007-2009 financial crisis, Admati et al. (2011) see strong reasons to question the social value of much of this debt creation that Gorton et al. (2011) advocate.12 The call for more equity capital and the use of less debt suggest a long-term transition to a banking landscape that is much different than that of today and hard to predict upfront. 2.4 Raising More Equity Capital: Transition Phase The road leading to higher capital levels entails other sorts of issues, such as debt overhang, information asymmetry and stigmatization problems (new-issuance costs or flow costs). Kashyap, Stein and Hanson (2010) explain that there is a crucial distinction to make when discussing costs of capital in relation to acquiring more equity capital. First, if a poorly capitalized bank is trying to attract more equity capital from the market, it could face debt overhang problems while better-capitalized banks do not. Second, costs associated with information asymmetry also play a bigger role when the bank in dispute is highly leveraged. Kashyap et al. (2010) state that the frictions of raising more equity capital are more severe than the ongoing costs of holding more equity capital.
2.4.1 Information Asymmetry

An important contribution to the information asymmetry discussion is the flow-cost theory, which is set up by Myers and Majluf (1984). They explain the difference between more and less information available for respectively firm management and outside investors. Assuming that management acts on behalf of existing shareholders, then an equity issue will be taken as a negative signal, since management prefers to sell shares when they think shares are overvalued. This is also known as the signaling effect (or stigmatization) and share issues will tend to be associated with negative share-price impacts. Because management knows that there is a negative impact of this

Admati et al. (2011) state that the financial crisis is due to high leverage ratios and that if the equity cushion was big enough, the crisis did not occur. On the other hand, Gorton et al. (2011) argue that the conversion of information-insensitivity debt into information-sensitivity debt (e.g. repo) is the cause of the financial crisis and not necessarily the level of debt (leverage).
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stigmatization, they will postpone or not propose an equity capital issuance. This disturbs the leverage reduction during the transition phase. If a bank faces higher capital requirements, it might not be raising new external equity and instead prefers to shrink its assets and stop lending. Kashyap et al. (2010) conclude that, in the sense of the Myers-Majluf model and empirical work they have surveyed, new capital requirements should be phased-in sufficiently, in order to reduce the information asymmetry problem and to give banks time to generate the necessary additional capital largely out of retained earnings and maintain lending activities normally. On the other hand, Admati et al. (2011) argue that if the share issue decision is not taken by the management, but required by the regulator, the negative signaling effect can be neutralized. They refer to the Troubled Asset Relief Program (TARP) in 2009, where banks didnt have a choice whether to accept government intervention or not, and the information asymmetry was not an issue. If new capital requirements are accompanied by regulation mandating all banks to issue new shares at a pre-specified scheme, the negative signaling effect would be removed, and banks have no reason to reduce lending in order to meet the new capital requirements during the transition phase (Admati et al., 2011). Also Admati et al. (2011) recommend regulators to postpone dividend payments by banks for a period of time, and use the retained earnings to build up bank capital. Again, if done under force of regulation, this will not lead to a negative signaling effect on the health of any particular bank (Admati et al., 2011).
2.4.2 Debt Overhang

In addition to the information asymmetry problem, poorly capitalized banks face debt overhang problems. Myers (1977) was the first to describe the problem of debt overhang. For a firm with outstanding debt, equity capital issuance reduces leverage. Leverage reduction of these firms benefits existing debt holders and providers of debt guarantees. For each unit of equity capital that is added to the balance sheet, debt becomes safer and a transfer of value takes place from shareholders to existing debt holders (dilution) during the transition phase. This transfer of value leads to underinvestment; new (partial equity financed) projects are not carried out, because dilution will occur (Myers, 1977). In a paper about debt overhang in relation to banks, Admati, DeMarzo, Hellwig and Pfleiderer (2012) state that shareholders do not want to reduce the leverage even if the reduction would not change the total value of the bank. In some cases, new equity

18

capital that is invested in good assets (loans with positive NPV) might increase the total value of the bank. Due to debt overhang and the addiction to leverage new loans are not provided (Admati et al., 2012). During financial crises, when the probability of default is significantly higher, debt overhang problems partly explain the credit rationing. Repayments of existing loans are used to strengthen the banks balance sheets. Figure 2.1 shows three options that are possible to reduce leverage in response to higher capital requirements:
Initial Balance Sheet Revised Balance Sheet with Increased Capital Requirements to 20%

New assets: 12.5

Equity: 22.5

Equity: 10

Equity: 20

Loans: 100

Deposits and Debt: 90 Loans: 50 Equity: 10 Deposits and Debt: 40

Loans: 100

Deposits and Debt: 80

Loans: 100

Deposits and Debt: 90

10% capital requirement

1) Asset Liquidation

2) Recapitalization

3) Asset Expansion

Figure 2.1: Alternative Responses to Increased Capital Requirements, source: Admati et al. (2012)

Assume the initial capital requirement is set at 10% and suppose that the bank has 100 worth of assets (loans). The bank is financed with 10 of equity capital and 90 of deposits, debt and other liabilities. Now assume that capital requirements are raised to 20%. Following figure 2.1, the first option is asset liquidation, where the bank delevers its balance sheet by liquidating 50 in assets and using the proceeds to reduce liabilities from 90 to 40. Option two is a pure recapitalization, where issuing 10 of additional equity capital and buying back 10 of debt satisfy the new capital requirement. The third option is a balance sheet expansion. Raising equity by 12.5 and using the proceeds to acquire new assets or provide new loans also satisfy the 20% capital requirement (Admati et al., 2012). Admati et al. (2012) analyze shareholders incentives to find out if shareholders have a preferred option. They find that, from shareholders perspective, all three options are equally undesirable because of the debt overhang problem (Admati et al. 2012). This is important to know, because if the asset liquidation was preferred and the transition period is accompanied by a significant number of assets sales, it could spark a fire sale and have a destabilizing effect in the midst of financial crisis. In any case, more equity

19

capital increases debt holders safety and value. Admati et al. (2012) emphasize that these problems would be less significant when the banking system is better capitalized. 2.5 Conclusion This chapter discussed important insights and concepts related to capital structure of banks, banks cost of funding and higher capital requirements. In conclusion, banks are special and have some unique dynamics on their balance sheets (e.g. deposits). However, some important corporate finance insights are applicable to banks and should be taken into account when discussing the capital structure of banks. The ModiglianiMiller theorem holds partially and is independent of CAPM. The theorem is also useful to expose and identify frictions and distortions. The impact of higher capital requirements on the total cost of funding is negatively affected mainly by two externalities. First, implicit and explicit government guarantees affect the banks cost of funding due to a discount on the interest rates on debt: the convenience yield. Second, the tax shield is also subsidizing debt and makes the total cost of funding cheaper. These problems, and many more issues, play a minor role when the banking system is better capitalized; hence higher capital requirements are necessary to reduce frictions and distortions. The theoretical analysis of discussing and implementing higher capital requirements must be segregated in two ways, namely having more equity capital and raising more equity capital. The self-fulfilling beliefs of banks that having more equity capital is expensive and the ROE is fixed are fundamentally flawed. Having more equity capital reduces the required return on equity, since risk is distributed among more shareholders. It is therefore misleading if banks engage in risky activities to remain their ROE constant. In the new equilibrium (steady state, when all banks are better capitalized), bank capital can be an attractive and safe asset class to hold in the portfolio, with a low risk profile and a reduced required return on equity. Raising more equity capital could transfer value from shareholders to existing debt holders. This so-called debt overhang problem makes the decision to acquire more equity capital difficult for banks shareholders and managers. Along with information asymmetry problems, high leverage ratios are hard to breach by raising more equity capital. The combination of these two problems demands that higher capital requirements should be phased in gradually. However, these problems can be alleviated if the regulator requires banks to postpone dividend payouts and to issue new equity capital on short notice under force of that same regulator.

20

3.

Empirical Studies on Higher Capital Requirements

This chapter surveys five recently published, empirical-based papers and publications on the effect of higher capital requirements on loan growth and bank lending spreads. In chronological order of publication it discusses Kashyap, Stein and Hanson (2010), King (2010), Angelini et al. (2011), Cosimano and Hakura (2011) and Santos and Elliot (2012). The assumptions and results of these studies are compared with the theoretical concepts and insights discussed in chapter two. These five studies empirically test the long-run impact of higher capital requirements. Their results relate to a new, steady state, equilibrium. Some of these papers mention the transition phase briefly by explaining debt overhang and asymmetry information problems. These problems are not involved in their empirical parts, with the exception of Santos and Elliott (2012). In some cases, chapter two will be complemented with other insights and arguments. A summary and conclusion form the end of the chapter. 3.1 Kashyap, Stein and Hanson (2010) Kashyap, Stein and Hanson (2010) examine the impact of substantially heightened capital requirements on large financial institutions, and on their customers. They begin their empirical study by validating the Modigliani-Miller theorem. A large sample of banks is used to test if the !"#$%& halves when the equity capital ratio is doubled (similar to Miles et al. (2012)). The regression results are roughly in line with what is predicted upfront. There is some empirical evidence that justifies the use of the Modigliani-Miller theorem for further calibrations. Note that Kashyap et al. (2010) assume, for simplicity matters, that debt is risk-free (!"#$ ), which implies the existence of a convenience yield. Their baseline regression results are not corrected for the loss of subsidized debt when the equity capital ratio is doubled. Thus, the Modigliani-Miller effect must be dampened. The second conclusion Kashyap, Stein and Hanson (2010) draw is that if the minimum capital ratio is raised by ten percentage points, the loan rates will increase by 25-45 basis points13 according to their methodology. This applies to the new equilibrium (steady state). They qualify this as a minor change in loan rates and small in absolute terms. The outcomes are only as good as the model that underlies them and the main assumption of the model is the loss of the tax shield when debt is replaced with equity. They assume the cost of long-term debt is 7% and the corporate tax rate is 35%. Thus a ten percentage points increase of the capital ratio would raise the lending spread with 25 basis points (=10% x 7% x 35%). Kashyap et al. (2010) correct for the loss of

13

100 basis points = 1 percent.

21

subsidized debt in an aggressive case (violation of the Modigliani-Miller theorem) and find an increase of the lending spread by 45 basis points. There is an incentive for banks to be highly leveraged, because of these benefits provided by a convenience yield and the tax shield. Admati et al. (2011) explain that when debt has indeed a tax advantage over equity, this assumption is correct, but irrelevant to capital regulation. Both capital regulation and tax rules are matters of public policy. Tax policy should aim at discouraging behavior that generates negative externalities, such as increases in leverage ratios. High leverage ratios raise the probability of bank failures and weaken the financial system. The probability of government intervention, using public funds, is also increased (Admati et al., 2011). The final conclusion of Kashyap, Stein and Hanson (2010) is that intense competition drives the banks in the direction of high leverage. The most competitive advantage that banks have is the ability to fund themselves cheaply (i.e. short-term debt or repo14). Even the smallest increase in cost of funding relative to direct competitors can lead to the loss of much business (Kashyap, Stein and Hanson, 2010). They also argue that substantially heightened capital requirements will lead to greater banking activity within the so-called shadow banking sector due to these competition forces. This phenomenon is also known as regulatory arbitrage. Kashyap et al. (2010) find empirical evidence that large banks in particular tend to hold less capital and are able to exploit regulatory arbitrage. Admati et al. (2011) point out that most activities and entities in the shadow banking system relied on commitments made by regulated entities, and thus were within regulators reach. They believe it is unhelpful in the context of the capital regulation discussion to refer to the shadow banking system like that. Capital regulation is focused on reducing excessive leverage and regulators should be able to assess the true leverage of banks. This includes banks contribution to the entities within shadow banking system that are being used to hide leverage and exposures (Admati et al., 2011). Obligations to the shadow banking system could be higher than expected. 3.2 King (2010) The second paper, a BIS working paper by King (2010), outlines a methodology for mapping the increases in capital and liquidity requirements proposed under Basel III to bank lending spreads. He finds that a one-percentage point increase (steady state) in the capital ratio can be recovered by increasing lending spreads by 15 basis points. This is a bigger change in the lending spread compared to the figures Kashyap, Stein and

14

For the role of repo financing, see Gorton (2010) and Gorton and Metrick (2010).

22

Hanson (2010) estimated with their methodology. Kings (2010) most important assumption is that the return on equity (ROE) and the cost of debt are unchanged when more equity capital is acquired. He argues that theoretically both the cost of debt and the cost of equity should decline as leverage decreases and the risk of default becomes smaller, but it is not evident that these theories hold in practice (King, 2010). According to King, this is due to implicit government guarantees on bank debt, which reduce the risk of default, leading shareholders to expect a lower ROE. At the same time King (2010) mentions the implicit subsidy on cost of deposits due to the deposit insurance schemes, lowering the cost of wholesale funding compared to firms with similar leverage ratios. As mentioned in chapter two, bankers argue that higher capital requirements will increase funding costs, since indeed more equity capital will reduce banks ability to benefit from these guarantees and subsidies. Following this reasoning, capital is indeed expensive. Admati et al. (2011) argue that this is not a legitimate reason for regulators not to propose new capital requirements. The existence of these subsidies cannot be neglected, but that does not justify high leverage ratios. Admati et al. (2011) find it paradoxical that the government subsidizes the leverage of banks at the same time that it recognizes that this leverage is socially very costly and considers imposing higher capital requirements to prevent the banks from taking advantage of this subsidy. Admati et al. (2011) make a clear distinction between private costs and social costs, which is important to do when empirically testing higher capital requirements. King (2010) seems to neglect this. Similar to the case of the tax advantage of debt, government guarantees on debt concern private costs of bank capital. Admati et al. (2011) take into account the default risks borne by the taxpayer and the costs of these risks to taxpayers as social costs. Once these costs are included, there is a strong case for requiring banks to have more equity capital. Equity cushions are valuable, as they reduce the likelihood and cost of the guarantees (Admati et al., 2011). Note that this refers to the new equilibrium (steady state). King (2010) holds the ROE and the cost of debt constant while calculating the effects of new capital requirements. This is contrary of what should happen according to the Modigliani-Miller theorem, as extensively stated in chapter two. Raising the amount of capital should reduce risk per unit of capital and thus lower the ROE. King (2010) mentions that it is possible to empirically identify an inverse relationship between bank

23

capital ratios and historical ROEs, with lower returns for more highly capitalized banks.15 Because there is a lack of data on secondary market prices for bank debt, the empirical relationship between bank capital ratios and the cost of wholesale funding is less clear (King, 2010). Therefore, King (2010) argues that it is reasonable to assume that ROE and cost of debt are unchanged despite new higher capital levels. This is false, since ROE does not adjust for risk. Kings (2010) reasoning shows a misunderstanding of the way in which risks must be taken into account when calculating the cost of funding. Referring to chapter two, the required return on equity is higher than the required return on debt and this difference reflects the greater riskiness of equity relative to debt. Reducing the amount of capital (increasing leverage) has an effect on the riskiness of debt and equity and, therefore, on the required expected return on equity. Modigliani and Miller (1958) state that, with or without tax advantages and public subsidies to debt and deposits, increasing the amount of equity simply re-distributes the total risk that is borne by investors in the bank, the right side of the balance sheet. The total risk of the bank is given by the risks that are inherent in the banks asset return, the left side of the balance sheet (Admati et al., 2011). According to the Modigliani-Miller theorem, changing the capital structure must affect the return on equity and cost of debt, therefore Kings (2010) assumption cannot hold. Kings (2010) calculations and test results are incomplete, since previous mentioned arguments are not taken into account. 3.3 Angelini et al. (2011) The third paper, a NY Fed Staff Report by Angelini et al. (2011), assesses the long-term economic impact of the new regulatory standards (the Basel III reform). In line with Kashyap et al. (2010) and King (2010), this third study also examines the steady state (new equilibrium). However, Angelini et al.s (2011) method is a completely different approach compared to Kashyap et al. (2010) and King (2010), which have studied the new capital requirements at the level of banks balance sheets and used partial equilibrium models.16 Angelini et al. (2011) address the impact of the new capital requirements on economic performance and fluctuations. They also discuss the adaption of countercyclical capital buffers on economic fluctuations. When the economy is booming (shrinking), capital ratios should be increasing (decreasing). Angelini et al. (2011) use different general equilibrium models to calculate output17, welfare18 and consumption. The general equilibrium theory assumes that investments and savings are

15 16

This is similar to the Modigliani-Miller effect mentioned in chapter two. Assuming other sectors are not affected due to the change in the banking sector, hence ceteris paribus. 17 Output is the volatility of macroeconomic variables. 18 The welfare-model of Van den Heuvel (2008) is a well-known example.

24

in equilibrium and equal, therefore savings are needed when capital investments increase across different sectors. A conversion of savings into investments in the financial sector changes the equilibrium of welfare, consumption and economic output for all sectors. Angelini et al.s (2011) focus is on the costs of the new regulation and how these costs affect the behavior of supply and demand in the whole economy. A highly stylized version of the new scenario (higher capital requirements, conversion of savings into investments) is translated into model inputs and different variables. The results, or the model output, are steady state values and volatility of key macroeconomic variables, which determine the new general (macro) equilibrium (Angelini et al., 2011). Angelini et al. (2011) derive three results about long-term economic performance, fluctuations and countercyclical capital buffers. The first result is that a one-percentage point increase in the capital ratio translates into a 0.09 percent output loss relative to the level that would have prevailed in the absence of capital tightening. Their interpretation of this figure is that the impact on long-term economic performance is modest, which is in line with results obtained in similar studies19 (Angelini et al., 2011). The second estimate is about the impact of higher capital requirements on economic fluctuations. According to Angelini et al. (2011), higher capital requirements should dampen output volatility (the magnitude of economic shocks). Their used models estimate that a one-percentage point increase in the capital-to-asset ratio reduces the standard deviation of output by 1.0 per cent, which they opine as a modest result. Angelini et al. (2011) also find that a one per cent increase in capital raises the lending spread with 13 basis points20. The final result of Angelini et al. (2011) is that a countercyclical capital buffer could have a more sizeable dampening effect on output volatility. The equity capital buffers that are accumulated in good times reduce the downward impact of an economy in recession. A modest loss of welfare, as Angelini et al. (2011) estimated, could suggest that increasing capital requirements reduces the ability of banks to provide loans or hold deposits, which can be consumed. Admati et al. (2011) claim that increasing capital requirements do not have to lead to a decline of welfare. Figure 2.1 from chapter two provides three options that are possible to reduce leverage. The third response, asset expansion, gives a bank the opportunity to increase the equity capital ratio, while at the same time providing new loans to the economy.

19 20

MAG (2010b), BCBS (2010b). King (2010) estimates a comparable increase.

25

Initial Balance Sheet

Revised Balance Sheet with Increased Capital Requirements to 20%

New assets: 12.5

Equity: 22.5

Equity: 10

Equity: 20

Loans: 100

Deposits and Debt: 90 Loans: 50 Equity: 10 Deposits and Debt: 40

Loans: 100

Deposits and Debt: 80

Loans: 100

Deposits and Debt: 90

10% capital requirement

1) Asset Liquidation

2) Recapitalization

3) Asset Expansion

Figure 3.1: Alternative Responses to Increased Capital Requirements, source: Admati et al. (2011)

Admati et al. (2011) argue that this example of a single bank is just as pertinent when analyzing the banking sector as a whole or even the overall economy, like Angelini et al. (2011) do with the general equilibrium theory. The assumptions made for most of the models that are used by Angelini et al. (2011) exclude an adjustment to higher capital requirements concerning the third option, according to Admati et al. (2011). Theoretically, if all banks use the asset expansion option to satisfy the new capital requirements, the whole economy would expand. Since savings and investments must be equal in the general equilibrium model, it is not realistic that massive asset expansion by banks is an obvious option.21 As an example, a combination of asset liquidation and asset expansion, where some banks become smaller and other larger, financed with new equity by a conversion of savings into investments is a more realistic option. In the particular model of Van den Heuvel (2008), used by Angelini et al. (2011), banks are financed only with equity and deposits, thus increased capital requirements are at the expense of deposits, resulting in a welfare loss under the models assumption that consumers derive utility from holding deposits (Admati et al., 2011). As option three suggested, banks can satisfy higher capital requirements without reducing their deposit base, therefore Admati et al. (2011) find it highly suspect if not meaningless to apply this model to assess the welfare costs of capital requirements. However, Admati et al. (2011) seem to forget that the new investments in bank capital must come from savings, since they must be equal. In order to expand the assets, like option three, savings must be converted into investments. In general equilibrium models this is seen as a loss of consumption and welfare (Angelini et al., 2011).

21

A conversion of deposits into equity does not expand the balance sheet (both liabilities of a bank).

26

Concluding, Angelini et al. (2011) seem to neglect the social costs that arose from misalignments and distortions underlying the systems breakdown in the crisis. Angelini et al. (2011) focuses on costs in terms of the loss of welfare and consumption. In 2008, Van den Heuvel concluded that capital requirements were too high and he estimated that one upper bound for the cost of a one-percentage point increase in capital requirements is $1.8 billion per year. Given these facts, Admati et al. (2011) find it remarkable that Van den Heuvels (2008) welfare-model is used by Angelini et al. (2011). The loss of output, consumption or welfare due to higher capital requirements is significantly smaller than the costs of the financial crisis (Admati et al., 2011). If more equity capital reduces the costs of financial crises, than equity capital should be taken into account as a benefit. 3.4 Cosimano and Hakura (2011) The fourth paper that is discussed, an IMF Working Paper by Cosimano and Hakura (2011), investigates the impact of the new capital requirements of Basel III on bank lending rates and loan growth (steady state, new equilibrium). The method used by Cosimano and Hakura (2011) models three variables simultaneously; the generalized method of moments (GMM). The first variable that Cosimano and Hakura (2011) regress is the choice of capital, depending on the capital requirement, interest rate on deposits, noninterest costs of loans and total assets (Cosimano and Hakura, 2011). The second regression variable is the loan rate, which is dependent of the first variable plus interest rate on deposits, costs of loans and economic activity. The last step they examine is the elasticity of bank loans, for which they use the loan rate from the second regression. The elasticity of bank loans indicates the effect of higher capital requirements and loan rates on loan growth. Cosimano and Hakura (2011) assume that higher capital requirements raise banks marginal cost of funding, which leads to higher lending rates. They also assume that the ROE is fixed, which means that all costs of increasing capital are reflected by a higher loan rate. This is a violation of the Modigliani-Miller theorem, as mentioned earlier. The last assumption is that bank liabilities consist only of equity and deposits (Cosimano and Hakura, 2011). Three different groupings of banks are (crosscountry) analyzed: 1) the 100 largest banks worldwide; 2) commercial banks or bank holding companies (BHCs) in advanced economies that experienced the 2007-2009 crisis; and 3) commercial banks or BHCs that did not experience the 2007-2009 crisis. The first finding of Cosimano and Hakura (2011) is that a one percent increase in the capital requirement (equity-to-asset ratio) raises the loan rate for the 100 largest banks with 12 basis points. For the second group, banks that faced the 2007-2009 crisis, a one percent increase is associated with a 9 basis points average increase in the loan rate.

27

The banks that did not experience the 2007-2009 crisis have a 13 basis point average increase. Cosimano and Hakura (2011) also find a 12 basis point increase in marginal cost of equity relative to the marginal cost of deposits, which is evidence against the Modigliani-Miller theorem. Chapter two explained that there is a Modigliani-Miller effect, thus not all assumptions hold in their pure form. A higher level of equity would reduce the riskiness of the bank equity such that the ROE declines. However, Cosimano and Hakura (2011) refer to the government guarantees and subsidies as a possible source of the higher cost of equity. Since there is less room for subsidized debt, as stated in chapter two, total cost of funding becomes higher and thus raising equity capital is expensive. It is therefore not surprising that they find these increases. Cosimano and Hakura (2011) use the increases in loan rates to estimate the loan demand or elasticity for the three groups and different countries. The 100 largest banks estimations imply a reduction in the volume of loans by on average 1.3 percent in the long run when Basel III is in force (1.3 percent increase of equity-to-asset ratio). Cosimano and Hakura (2011) use 2007 data as baseline scenario, which is outdated (see paragraph 2.5). For banks in countries that experienced the 2007-2009 crisis, implementing Basel III would reduce loan growth with 4.6 percent on average and 14.8 percent for banks in countries that did not experience the 2007-2009 crisis (Cosimano and Hakura, 2011). According to Cosimano and Hakura (2011), the wide variance in the results of loan rate increases and loan demand decreases reflects the differences between countries interest elasticity of loan demand and banks net cost of raising equity.22 Admati et al. (2011) state that highly leveraged banks are generally subject to distortions in their lending decisions, such as frictions23 associated with governance and information. This may lead to worse lending decisions compared to a better-capitalized bank. If shareholders and management of a highly leveraged bank work on the basis of
ROE,

they have incentives to make excessively risky investments, especially when

governments guarantee debt. The upward potential, a high ROE, is intended for shareholders and managers, while the downward potential is shifted to taxpayers. Cosimano and Hakura (2011) show that higher capital requirements raise lending rates and reduce loan growth. Admati et al. (2011) would see this as a social benefit, since excessive lending is reduced. The reduce in loan growth is not a necessity as is shown in

Differences in cost of capital are due to different tax policies and ex- and/or implicit government guarantees on debt and deposits across countries. 23 i.e. agency theory, moral hazard, asymmetric information, debt overhang.

22

28

figure 3.1, thus there should be no concern with any negative impact on the economy of increased equity capital requirements (Admati et al., 2011). However, this argument is questionable when a general equilibrium method from Angelini et al.s (2011) paper is used where savings and investments are assumed to be equal. 3.5 Santos and Elliott (2012) As stated in the introduction of this thesis, the first reason for higher capital requirements is to strengthen the resilience of banks and the banking sector (BCBS, 2010). The previous four studies showed that, with or without correct and justified assumptions, higher capital requirements result in higher cost of funding and ultimately higher loan rates in a new equilibrium. In addition to higher loan rates due to the loss of tax advantage and government guarantees, Santos and Elliott (2012) compose three extensions of methodologies used by Kashyap et al. (2010), King (2010), Angelini et al. (2011) and Cosimano and Hakura (2011). These extensions lead to substantially lower net economic costs and are more in line with arguments of Admati et al. (2011). Santos and Elliott (2012) state that financial reform comes at a price and that higher capital requirements do add operating costs for banks that result in higher loan rates. However, Santos and Elliott (2012) estimate in their study that loan rate increases will likely be significantly smaller compared to King (2010) and Angelini et al. (2011).24 The first extension of Santos and Elliott (2012) is that market forces demand banks to have greater safety margins above the minimum capital requirement. They state that simply comparing the new Basel capital requirements with the old misses the crucial point that banks hold capital on top of the minimum requirements, as a result of their own desire to operate safely and because of pressure from the markets and rating agencies (Santos and Elliott, 2012). Therefore, Santos and Elliott (2012) use the end2010 levels as baseline for their estimates, which are higher than the Basel II capital requirements. The distance between end-2010 levels and Basel III is smaller. The second extension of Santos and Elliott (2012) assumes that banks will cut costs and take other measures to reduce the effect on loan rates and remain competitive. This accounts for an average reduction of 14 basis points on the lending rate (end-2010

24

In the IMF Staff Discussion Note by Santos and Elliott (2012), the estimates are mainly compared to official BIS,

IIF and OECD studies.

29

levels versus Basel III capital requirements). Santos and Elliott (2012) mention eight different bank responses to cost increases which they have included in their study.25 The final extension is more in line with Admati et al. (2011), namely investors will lower their required rate of return on bank equity when the bank reduces its leverage and improves safety (Santos and Elliott, 2012). Holding the ROE fixed at a high level is misleading, as explained in chapter two. With these three extensions taken into account, Santos and Elliott (2012) estimate that average loan rates increase by 28 basis points in the United States, 17 basis point in Europe and 8 basis points in Japan in the long term because of the new capital requirements. Santos and Elliott (2012) mention by comparison that the smallest step by which central banks change the interest rate is 25 basis points, which has no dramatic effect on the economy. Note that Santos and Elliott (2012) assume that during the transition phase many permanent cost-saving measures are implemented. 3.6 Conclusion This chapter analyzed five empirical-based studies that researched the impact of higher capital requirements on bank funding costs. The assumptions made in these studies are compared with the theory of chapter two. The first four studies mainly examined the cost side of higher capital requirements in a new equilibrium, the steady state. Overall, some benefits of higher capital requirements are mentioned, but generally not taken into account in the empirical tests and calculations. King (2010), Angelini et al. (2011) and Cosimano and Hakura (2012) find substantial increases of funding costs when higher capital requirements are implemented. The figures are in the range of 12 to 15 basis points for each percentage point that equity capital increases. However, under the assumption of fixed and high-level ROEs and neglecting social benefits of a bettercapitalized banking system, these conclusions are misleading, flawed and/or incomplete. Admati et al. (2011) and Miles et al. (2012) advocate an empirical analysis of the impact of higher capital requirements that considers not only costs, but also benefits of increased equity capital ratios. Such an analysis requires a clear distinction between costs and benefits to individual banks (private costs and benefits) and overall economic or social costs and benefits. The empirical studies discussed in this chapter show that private costs of banks may rise. The loss of subsidized debt on the balance sheet when more equity capital is acquired cannot be ignored. On the other hand, private benefits

See Santos and Elliott (2012, p. 8). Many costs savings can be realized due to increased safety and lower volatility. Admati et al. (2011) mention these effects as the largest benefit of increased capital requirements.
25

30

are difficult to quantify when the ROE is assumed to be fixed. Therefore the outcomes are biased to the cost side of higher capital requirements. For a more balanced empirical test of a new equilibrium, the following four factors should be included (Miles et al., (2012)): 1) Changes in required return on debt and equity as capital structure changes. 2) Changes in weighted average cost of capital (WACC) due to a different capital structure and tax treatments of debt and equity. 26 3) A lower probability of banking problems as equity buffers rise (safety net). 4) Economic costs generated when banking sector problems arise (bailouts). The empirical parts of the studies by Santos and Elliott (2012) and Miles et al. (2012) do take into account these beneficial factors and find significantly lower increases of steady state funding costs. Furthermore, Miles et al. (2012) even find that the optimal level of bank capital relative to the proportion of GDP is between 8 and 10 percent of total bank assets.27 This estimation is twice the capital requirement of Basel III. The five papers discussed in this chapter generally agree that public policies, such as the corporate tax system and implicit government guarantees, create subsidized debt. The main conclusion that can be derived from the empirical studies is that most of the increase of funding costs due to higher capital requirements is caused by the loss of this subsidized debt on the balance sheet (steady state). This subsidized debt creates an incentive for banks to prefer debt financing and to be highly leveraged. The transition towards a better-capitalized banking system is easier when these negative externalities are removed. Therefore, higher capital requirements should be complemented with reforms of policies concerning the corporate tax system and implicit government guarantees.

26 Note that all analyzes discussed in this chapter assume that asset risk and return are unchanged in a new
equilibrium (for simplicity matters). As stated in chapter two, the self-fulfilling belief that equity capital is expensive may cause risk-seeking bank managers during the transition phase. Santos and Elliott (2012) add to this that banks will cut operational costs to increase equity capital buffers and remain competitive. 27 The capital must be explicitly loss absorbing.

31

PART II 4.

Tax Shield, Government Guarantee and Policy Reforms

Tax Shield on Debt

The first part of this thesis, chapters two and three, eventually showed that tax policies and government guarantees are serious distortions in the discussion about higher capital requirements and bank capital structure. The second part, chapters four and five, respectively scrutinizes the corporate tax policy and implicit government guarantee. This chapter investigates, as an example, the Dutch situation of how the tax shield on debt works and what the relative size is. The theory and empirics discussed in part I clarify that high-leveraged banks benefit from the tax shield and that deleveraging creates a loss of tax shield in a new equilibrium. Since interest payments on debt are fiscally deductible, banks have an (implicit) incentive to prefer debt when financing new loans. For example, if a bank pays 7% interest rate on their debt, it actually costs 7% x (1 corporate tax rate). This fiscal benefit, the tax shield, is part of many funding cost calculations. Banks earnings are significantly higher due to lower tax payments. This negative externality encourages banks to be more leveraged. Therefore, this chapter ends with a possible reform of the corporate tax policy. 4.1 The Methodology of Debt Tax Shield Calculation In a straightforward cost of capital or funding cost calculation the interest rate on debt, determined by !"#$ , is corrected for the corporate tax rate, ! : =
! ! !! ! ! !!

!"#$%& +

!"#$ 1 !

(5)28

An annual report of a bank does not provide a calculation for the size and value of its tax shield. A very simplified example shows the methodology how it is accounted. Assume bank A having 100 interest income (e.g. loans and mortgages) and 72 interest expenses (e.g. debt and deposits). Also assume that bank B is a 100%-equity financed bank (no debt or deposits, therefore no interest expenses) with similar assets providing 100 interest income. The profit and loss accounts of both banks state the following: Bank A Interest income Interest expenses Profit Taxes (tax rate 25%) Net profit 100 -72 28 7 21 Bank B Interest income Interest expenses Profit Taxes (tax rate 25%) Net profit 100 0 100 25 75

Table 4.1: Profit and Loss Account, Tax Shield, source: author compilation

28

Berk and DeMarzo (2008) Corporate Finance, Pearson Education Ltd.

32

The tax shield of bank A is interest expenses x 25% = 18, which is the difference between the tax expenses of bank A and B (25 - 7 = 18). The key insight of this example is that investors of the leveraged bank, debt and equity holders of bank A, receive 93 (72 + 21), while those of bank B only obtain 75. Note that the assetsides of the balance sheets of banks A and B are 100% comparable. The difference of income that investors of bank A and B obtain, is the tax shield of 18 (93 - 75). Thus, investors of a (leveraged) bank can capture more income if leverage increases, while the government misses tax revenues.29 Hence, leverage is implicitly subsidized. Many Western countries allow tax deductions for expenses made to generate revenue, mostly by taxing gross profits. As mentioned in chapter two, banks are special and use debt to provide liquid securities to the economy, such as deposits and short-term debt. This debt includes many interest expenses, whereby tax deductibility plays a bigger role for banks compared to non-financial firms. Admati et al. (2011) state that the current tax shield on debt induces a distortion in the allocation of public funds between firms that can borrow extensively (e.g. banks) and firms that use more equity (non-financial companies). Given the special role that banks have and given the high levels of bank debt, the impact of the tax shield grew significantly to an undesirable extent. 4.2 The Size of the Dutch Bank Tax Shield As an example and illustration of the distortion, this paragraph quantifies the total size of the Dutch tax shield on bank debt over the period 1999-2012 for the largest three banks
ING, ABN AMRO

and Rabobank. The main factors that determine the relative size of the tax

shield are leverage, interest rates on debt and corporate tax rates. 30 31 These three factors are all positively correlated with the size of the tax shield. The first two factors are applicable to individual banks and can be determined by banks themselves. Policy makers set the third factor, the corporate tax rate. The corporate tax rate in the Netherlands has declined from 35% in 1999 to 25% since the beginning of 2011.

1999-2001 35%

2002-2004 34,5%

2005 31,5%

2006 29,6%

2007-2010 25,5%

2011- 25%

Table 4.2: Corporate Tax Rate in the Netherlands 1999-2012, source: Dutch Ministry of Finance

29 30 31

Note that from a governments perspective the tax shield (debt subsidy) is not an actual expense. Examples of interest rates are LIBOR, EURIBOR, ECB interest rates, Federal Funds Rate and deposit rates. The last part of equation (5)
! ! !!

!"#$ 1 ! shows that leverage

! ! !!

, total assets ( + ), interest

rates !"#$ and corporate tax rates 1 ! are correlated with the tax shield on debt.

33

The leverage of ING, ABN AMRO and Rabobank is quite different over the period 1999-2012. While Rabobank is most stable (total assets between 17,1 and 20,9 times their equity),
ING

and ABN AMRO have chosen relatively more debt to finance their assets. INGs balance

sheet only contained 2,05% of loss-absorbing equity capital at the end of 2008. Table 4.3 and figure 4.1 show all ratios from 1999 to 2012:

1999
ING ABN AMRO

2000 22,4x 30,5x 19,0x 2007 33,2x 33,3x

2001 27,6x 36,5x 19,7x 2008 48,7x 38,9x

2002 32,0x 37,3x 17,6x 2009 29,9x 24,8x

2003 31,3x 33,4x 17,1x 2010 29,0x 31,1x

2004 29,8x 43,9x 19,2x 2011 28,0x 35,4x

2005 30,1x 36,4x 20,9x 2012 21,5x 28,1x

13,6x 27,0x 18,7x 2006 29,7x 38,1x

Rabobank
(Cont) ING ABN AMRO

Rabobank 20,3x 19,9x 20,4x 19,2x 18,9x 20,4x 20,9x Table 4.3: Leverage (Equity Multipliers) 1999-2012 of Three Largest Dutch Banks, source: annual
reports and author calculation

60

50 Leverage (Equity Mul1plier)

40

30

ABN AMRO ING Rabobank

20

10

0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Figure 4.1: Leverage (Equity Multipliers) 1999-2012 of Three Largest Dutch Banks, source: annual reports and author calculation (appendix 1)

34

Some key interest rates that are applicable or relevant to debt financing are given in figure 4.2. The EURIBOR / LIBOR and ECB deposit rate are most frequently used in banking and have peaks in 2000-2001 and 2007-2008, during bull markets.

7,00% 6,00% Interest Rate 5,00% 4,00% 3,00% 2,00% 1,00% 0,00% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Figure 4.2: Key Interest Rates 1999-2012, source: DNB and author compilation (appendix 2)

Eurozone Bonds 10-y Avg. 3-month Saving Deposit Rate EURIBOR 12-month LIBOR ($) 12-month ECB Deposit Rate

The combination of these three factors, respectively the corporate tax rate, leverage and interest rates, displays that the tax shields are at their largest in 2000-2001 and 20072008. As leverage and interest rates increases, so does the tax shield. The extent to which the relative size of the tax shield increases when leverage increases depends on the type of debt instruments that are issued by the individual bank and in what volume. Some debt securities are more volatile (e.g. when linked to the EURIBOR or LIBOR), while deposits have a more stable interest rate. ING stands out in 2008 with an all time high leverage, while at the same time interest rates are at their highest points. Figures 4.3 and 4.4 (see next page) indicate that ING indeed deviates from ABN AMRO and Rabobank. The absolute sizes of the tax shields on debt of ING, ABN AMRO and Rabobank show similar movements up to 2004, with ABN AMROs peak of 9.7 billion at the turn of the century (figure 4.3). From 2004 to 2008 the size of INGs tax shield grows rapidly to a maximum of 22.2 billion. This number indicates the impact and magnitude of the subsidized debt distortion. The tax shields of ABN AMRO and Rabobank decline as a portion of total assets, contrary to INGs tax shield prior to the financial crisis (see figure 4.4). This is not due to external factors, but inherent to INGs strategy and management decisions. Why ING differs so much from the other banks is not certain, based on these figures. It could be that large quantities of INGs new debt are linked to interest rates that rise sharply, like EURIBOR or LIBOR. The growth of ING Direct and its exposure to US mortgages is also a possible explanation for this striking deviation.

35

 25.000

20.000

15.000

10.000

ING Rabobank ABN AMRO

5.000

0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Figure 4.3: Tax Shield on Debt (In Millions), source: annual reports, Dutch Ministry of Finance and author calculation (appendix 3)

2,00% 1,80% 1,60% 1,40% 1,20% 1,00% 0,80% 0,60% 0,40% 0,20% 0,00% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Figure 4.4: Tax Shield as a Percentage of Total Assets, source: annual reports, Dutch Ministry of Finance and author calculation (appendix 3)

ING ABN AMRO Rabobank

36

Banks are not solely relying on interest income and expenses. They also have significant fee revenues (or commission) that are part of their profits. Depending on which strategy they choose, banks mutually differ in the relationship between interest income and fee income. This is a fourth factor that influences the tax shield. Figure 4.5 expresses the contribution of fee income as a percentage of the combined revenues.

50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

ABN AMRO ING Rabobank

Figure 4.5: Fee Income as a Percentage of Total Interest and Fee Income, source: annual reports and author compilation (appendix 4)

This figure and the graphs of appendix 4 show that ABN AMRO was focusing more on fee income compared to their most direct competitors. It also demonstrates that fee income is of less importance after the financial crisis of 2007-2009, presumably because investment-banking activities are reduced and these banks return to basics. This increases the relative weight of the tax shield and the distortion of subsidized debt. As is clear from the preceding figures, the tax shield on debt is large and creates a significant distortion in favoring debt finance over equity finance in the Netherlands. Debt financing is made cheap. This distortion can be taken away by reforming the corporate tax system and establish equal treatment of debt and equity. 4.3 The Future of the Tax Shield Higher capital requirements reduce the ability to benefit from the tax shield on debt, because less leverage results in a smaller tax shield. Increasing capital requirements does not take away the distortion of tax advantages that subsidize leverage. According to Admati et al. (2011), tax policies should discourage behavior that generates negative externalities (high leverage and high risk of failure) and encourage behavior that generates positive externalities (deleveraging and lower risk of failure). As paragraphs 4.1 and 4.2 pointed out, the tax shield on debt significantly lowers the tax expenses if banks are more leveraged. Investors of high-leveraged banks capture more income

37

compared to their better-capitalized competitors, due to the tax shield on debt. A reform of the tax shield should be designed in such a way that the fiscal incentive shifts to equity financing, while total tax expenses remain more or less unchanged. Therefore, phasing out the tax shield on debt could be done stepwise and during a long and orderly transition period.32 The most simple and obvious solution is to remove the tax deductibility of interest payments on debt, whereby tax is paid over gross interest income instead of net interest income. Debt and equity are now treated equally from a fiscal perspective and the fiscal incentive to finance the activities with debt is removed. New investments, e.g. loans or acquisitions, no longer have a tax benefit on debt (or equity) and high leverage ratios arent fiscally favored. However, this means that banks have to pay enormous amounts of tax, namely several times their profit. This will increase the price of a loan (correction for a higher tax base) and give an unbalanced incentive to focus more on fee income. On the other hand, a full tax exemption on interest income means de facto that banks do not have to pay taxes. The current banking tax could be expanded to correct for this, but that is highly sensitive for subjective measurements. A less cumbersome solution is to set a maximum on the tax deductibility of interest expenses in order to remove the negative externality (incentive to prefer debt financing and high leverage). At the same time, the operating profit that banks obtain through net interest income could be less taxed, either by exemption or a lower corporate tax rate for that specific profit.33 The challenge is to hold the reduction of the deductibility similar to the exemption in absolute numbers, so that total tax payments remain about equal. Such a reform will remove the incentive for banks to finance their activities with debt, since it is significantly less subsidized. It is important to notice that such radical tax reforms will only have a chance of success if they are set internationally in order to establish a level playing field. Finally, if the current tax policies will not be reformed, banks will benefit less from the tax shield on debt when higher capital requirements (Basel III) are implemented. On the one hand, public policy makers require banks to reduce leverage, while on the other hand they conserve tax policies that incentivize excessive leverage. This is quite paradoxical and inconsistent. Thus, tax policy reforms are of great importance.

Van Dijkhuizen (2012) proposed similar reforms for mortgage interest deduction and income taxes in the Netherlands. 33 The tax rules that apply to fee income are excluded of these reforms, since the fiscal treatment of fee income does not create negative externalities that encourage banks to be highly leveraged.
32

38

5.

Government Guarantees and Recapitalization

This chapter analyzes implicit government guarantees, the second large distortion that affects the banks cost of debt and equity. Large and complex banks are labeled as Systemically Important Financial Institutions (SIFIs), too-big-to-fail (TBTF) or tooimportant-to-fail (TITF). Their debt contains a convenience yield, as explained in chapter two. Investors in SIFIs know that bankruptcy will not occur, since governments (implicitly) guarantee that they will step in to prevent this. Therefore, debt investors are willing to accept a lower required rate of return. Hence, the cost of debt does not fully reflect the inefficiencies of excessive leverage caused by implicit government guarantees. If this debt is replaced by equity capital, due to higher capital requirements, banks will lose a share of this subsidy. This chapter begins with explaining how implicit government guarantees affect the banking system. The second paragraph shows, as an example, calculations of the size of the implicit government guarantee and the total implicit subsidy in the Netherlands. This chapter concludes with a possible solution that lowers the distortive effects of the implicit government guarantee. 5.1 Impact and Consequences of Government Guarantees The recapitalizations of many banks all over the world in 2008 and 2009 provide examples of implicit government guarantees that became explicit. Governments had to bail out large, complex and high-leveraged financial institutions to avoid a breakdown of the financial system. As stated in chapter two, there is an important distinction between raising more equity capital and having more equity capital. High-leveraged banks find it difficult to increase the equity capital ratio due to debt overhang problems and information asymmetry. As to debt overhang problems, for each unit of capital that is acquired, debt holders risk is reduced. The formal characteristics of debt do not change, but since risk is distributed among more shareholders, this debt becomes safer and thus more valuable. This transfer of value creates an incentive for managers and shareholders to maintain excessive leverage and to postpone equity capital issuances to prevent dilution. This debt overhang problem is exacerbated by the implicit government guarantee. In the absence of the implicit government guarantee, debt holders have a disciplining effect on management. They monitor the company and its managements strategic choices to ensure that the company will pay back the debt instead of going bankrupt due to

39

excessive risk-taking. Since debt holders know that the government will intervene to prevent a potential default, their market discipline reduces. This may result in a preference for high leverage and excessive risk-taking incentives by banks. Once banks are better capitalized under pressure of higher capital requirements the debt overhang problem is solved or at least plays a minor role depending on the amount of new equity capital. If there is sufficient equity capital in the steady state, banks can internalize losses and depreciations using their own buffer. In this case, implicit government guarantees are less important and the likelihood of a bailout is significantly reduced. There are more distortive effects of implicit government guarantees. For example, the convenience yield on debt is only obtainable by SIFIs. Small banks do not have the implicit guarantee and pay a relatively higher required return on debt. Therefore, their funding costs are higher and competitiveness is reduced. This shifts business to large banks and enhances the too-big-to-fail problem. Noss and Sowerbutts (2012) state that the implicit government guarantee also attracts more resources from other sectors of the economy to the financial sector. Thus, the guaranteed banking sector as a whole has a competitive advantage over those sectors that are not or less guaranteed. Besides implicit government guarantees, there are explicit guarantees. The most explicit form of a government guarantee is the deposit insurance, which is partially financed by the sector itself. The Federal Deposit Insurance Corporation (FDIC) and the Dutch Deposit Guarantee Scheme (DGS) are two examples of explicit guarantees, which work as an insurance for deposit holders. This system protects small deposits holders from losing their money due to insolvency of the bank. The insurance is also established to prevent bank runs. For an extensive discussion of deposit insurance, see Diamond and Dybvig (1983, 2000) and Pennacchi (2009). 5.2 The Size of the Dutch Government Guarantee This paragraph estimates the size of the implicit government guarantee of the three largest Dutch banks over the period 1999-2012, similar to the tax shield calculation made in paragraph 4.2. The impact of the implicit government guarantee on bank funding costs is indirectly observable. Therefore, estimating the total size of the implicit government guarantee is subject to a degree of judgment and some severe assumptions. According to Gorton et al. (2011), bank debt contains a convenience yield. One method to calculate the size of the implicit government guarantee is to multiply all outstanding, interest rate-sensitive debt (minus deposits, which have an explicit guarantee) with this convenience yield. The credit spread between bonds issued by small (non-SIFI) and large

40

(SIFI) financial institutions is another example of a convenience yield. Small banks do not enjoy the benefits of the government guarantee and thus issue bonds with a higher credit spread (or risk premium) compared to large banks. This method is based on the size of banks, where large banks have a government guarantee and a lower probability of default. Gorton et al. (2011) use an average convenience yield of 72 basis points that is found by Krishnamurthy and Vissing-Jorgensen (2010) over the period 1926-2008. Baker and McArthur (2009) find a lower funding cost advantage using the size-based method, ranging from 9 to 49 basis points for US banks. A second method, used in this paragraph, is based on credit ratings provided by Standard and Poors, Moodys or Fitch. These credit rating agencies often issue two ratings: the supported credit rating and the stand-alone credit rating. The first rating reflects the actual costs of funding that are observed in the market. This is the normal rating that is used by the market and reported in annual reports. The second rating is based on an estimate of funding costs that banks would pay without the government guarantee, in a stand-alone situation (Noss and Sowerbutts, 2012). The distance (number of credit rating steps or notches) between these two ratings is dependent on macroeconomic events and the likelihood of government support. Figure 5.1 shows how Moodys estimated this over the period 1999-2012:

2,5 2 1,5 1 0,5 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Figure 5.1: Notches Between Stand-Alone and Supported Credit Ratings, source: Moodys

Notches

Moodys (2011) state that impact of the implicit government guarantee is equal to zero notches from 2002 to 2006. This assumption does not neglect the existence of an implicit government guarantee, but it implies that the market estimates the likelihood of government intervention to be small, whereby the market is indifferent between supported and non-supported banks. The difference between stand-alone and supported credit ratings is assumed to be two notches since the beginning of the financial crisis in

41

2007.34 Recently, Moodys rescaled it to one notch in 2012 for US banks and two notches for Dutch banks (Moodys, 2012). The credit spread between the stand-alone and supported rating (notches) captures the margin that is needed to calculate the size of the implicit government guarantee. One way to obtain the margin is to use the average credit spread between corporate bonds and government bonds.35 All outstanding, interest rate-sensitive debt (minus deposits) multiplied by this margin gives an estimation of the total size of the implicit government guarantee. Assuming that all outstanding, interest rate-sensitive bank debt is affected by the implicit government guarantee could be considered as a broad approach. A more conservative approach is to use issued bonds only. Table 5.1 shows the total size of the implicit government guarantee over the period 1999-2012, using Moodys credit ratings and the method described above. Table 5.2 shows the lower, conservative variant. 1999
ING ABN AMRO

2000 217 164 356 2007 900 797 146

2001 191 323 208 2008 938 705 584

2002 0 0 0 2009 3.735 2.106 1.274

2003 0 0 0 2010 2.892 794 383

2004 0 0 0 2011 12.474 4.150 512

2005 0 0 0 2012 7.884 3.435 573

214 148 69 2006 0 0 0

Rabobank
(Cont) ING ABN AMRO

Rabobank

Table 5.1: Implicit Subsidy High (In Millions) 1999-2012, sources: annual reports, Moodys, Bloomberg and author calculations (appendix 5)

1999
ING ABN AMRO

2000 33 42 100 2007 80 210 71

2001 30 87 70 2008 116 178 285

2002 0 0 0 2009 684 794 756

2003 0 0 0 2010 570 442 236

2004 0 0 0 2011 2.294 2.162 299

2005 0 0 0 2012 1.721 1.965 335

46 38 22 2006 0 0 0

Rabobank
(Cont) ING ABN AMRO

Rabobank

Table 5.2: Implicit Subsidy Low (In Millions) 1999-2012, sources: annual reports, Moodys, Bloomberg and author calculations (appendix 5)

Ueda and Weder di Mauro (2012) assume three to four notches based on Fitch credit ratings For example, the spread between a US government bond and an Aaa-rated bond issued by a US bank is 31 basis points in 1999. If the spread of a Baa1-rated bond issued by a bank is 143 basis points, then the margin between the Aaa-rate and Baa1-rate is 112 basis points in 1999 (see appendix 5, source: Bloomberg).
35 34

42

The results of the calculations show that the implicit subsidy of ING and ABN AMRO increased substantially after the financial crisis, while Rabobank demonstrates a more stable impact of the implicit subsidy. As stated in chapter four, the leverage ratios of ING and ABN AMRO are higher than Rabobanks, which have an influence on the credit ratings of these banks. The increase of the implicit subsidy is caused by reduced confidence that markets have in banks. This significantly lowers the credit ratings during and after the financial crisis. Second, the number of notches between stand-alone and supported has increased, whereby the margin and spreads grow exponentially. Rabobank is the least leveraged bank and has a relative small and strong balance sheet. Due to Rabobanks relatively low leverage and high credit ratings, the margins between supported and stand-alone are smaller. Hence, the implicit subsidy of Rabobank is the smallest of these three banks. Still, the most conservative approach of this method yields an annual average implicit subsidy of 330 million over the past six years for Rabobank. In other words, implicit government guarantees ensure that not all inefficiencies of high leverage are reflected in the costs of bank debt funding. In absence of the government guarantee Rabobank would have paid 330 million per year more interest on their issued bonds, which is approximately 15% of their total annual profit. As stated before, these calculations are subject to a degree of judgment. The credit ratings and the number of notches between supported and stand-alone credit ratings are based on Moodys interpretation.36 Applying the same credit spread or margin to all different types of debt instruments on the balance sheet is also objectionable. Therefore, the conservative approach (issued bonds only) is included and considered to be more accurate. Other authors using the credit rating-based method find different margins. For example, Ueda and Weder di Mauro (2012) find a margin of 60 to 80 basis points over the period 2007-2009 for US banks. Using the same method and different credit spreads, Van Tilburg (2012) estimated that the implicit subsidy of the three largest Dutch banks in 2011 is between 3,8 and 11,4 billion. It is clear that the exact benefit of implicit government guarantees is hard to quantify. Despite of the bandwidth of the estimations, these methods indicate that the problem has a significant impact on bank funding costs. They also expose differences between better-capitalized and high-leveraged banks.

Note that up until the financial crisis credit rating agencies made mistakes in their judgments. This calculation is based on credit ratings, thus the results are not entirely objective. Most important is that the differences between ING, ABN AMRO and Rabobank can be made, since all three banks are subjected to the same method.
36

43

5.3 Recapitalization of the Banking System Paragraphs 4.2 and 5.2 show that the distortive effects of the tax shield and implicit government guarantees are significantly reduced when a bank is better capitalized. This also implies that high-leveraged banks exploit the implicit subsidy relatively more. Their incentive to acquire more equity capital is negatively influenced by these distortions, which enlarge the debt overhang problem (transition phase). Besides the loss of subsidized debt, banks do not have importance in raising equity capital because dilution may occur. Therefore, it seems inevitable that governments and/or regulators should intervene to recapitalize the banking system.37 Higher capital requirements are one form of government intervention, but can be complemented with other solutions. For example, Admati et al. (2011) advocate a regulatory rule that forces all large banks to issue equity capital according to a fixed schedule. This may help to reach the higher capital requirement faster and to avert the stigmatization of an equity issuance, but it does not mitigate the other problem of the transition phase, debt overhang. Admati et al. (2011) also advocate that dividend payments should be suspended during the transition phase, because retained earnings should be used to increase the equity cushion. Although these proposals create better-capitalized banks more efficiently, the existing debt holders benefit from this situation. The challenge is to find an instrument that deals with the lack of incentives of highleveraged banks to acquire more equity capital timely, hence solves the debt overhang problem. Calomiris and Herring (2011) describe such an instrument and propose a contingent convertible (CoCo) capital requirement in addition to higher capital requirements. Contingent convertible capital is a debt instrument that converts to equity when the equity capital ratio falls below a certain threshold. This mandatory conversion of debt to equity is a direct form of recapitalization for which the term bail-in is used frequently. The automatic conversion ensures that banks can avoid the debt overhang problem described earlier. Note that the risk and probability of conversion lead to a higher required rate of interest by investors in CoCos compared to normal debt (based on theoretical insights of chapter two). Calomiris and Herring (2011) state that if banks have a choice between issuing equity capital or CoCos, they should prefer CoCos. The dilutive effect of a forced equity capital issuance immediately takes place. As to CoCos, dilution only occurs when debt is converted into equity capital depending on the conversion rate. Calomiris and Herring

See e.g. Scharfstein and Coates (2009), Admati et al. (2011, 2012 and 2013), and Philippon and Schnabl (2012) for a more detailed discussion about the need of government intervention.
37

44

(2011) state that the primary aim of a CoCo should be to incentivize the voluntary, preemptive, and timely issuance of equity into the market as a means of avoiding highly dilutive CoCo conversion. CoCos also facilitate bail-ins and signal bank risk, but the encouragement of timely equity capital issuances is far more important. According to Calomiris and Herring (2011), the design of a CoCo requirement should include at least: a large size of CoCos, a credible and observable moment of conversion (the trigger) and a conversion rate that is dilutive of existing shareholders. If a bank faces significant losses that will trigger the automatic conversion of debt into equity capital soon, it will avoid this by issuing new equity capital timely. The large amount of CoCos being converted, combined with the dilutive conversion rate, must be an unattractive option compared to issuing new equity capital timely. Existing shareholders and management anticipate the possibility of a conversion and will have strong incentives to be adequately capitalized and have accurate risk management (Calomiris and Herring, 2011). Lastly, the role of implicit government guarantees is significantly reduced if such a CoCo requirement is implemented. As explained in paragraph 5.1, debt holders have a less disciplining effect on banks management and strategic decisions in the presence of implicit government guarantees and in the knowledge that the bank is too-big-to-fail. CoCo holders are keen to prevent conversion, as well as existing shareholders that fear heavy dilution, therefore the disciplining effect will return. Second, if a bank faces significant losses of equity and is not able to issue new capital, the conversion of CoCos reduces the likelihood and magnitude of a government bailout. The higher the CoCo requirement, the smaller is the role of the implicit government guarantee.

45

6.

Summary and Conclusion

This thesis answers the question if higher capital requirements increase total bank funding costs. The first part provides an analysis of theoretical and empirical studies. The starting point of this analysis is the Modigliani-Miller theorem that is explained in chapter two. Discussing the impact of higher capital requirements on funding costs and capital structures requires a clear distinction between the steady state and the transition phase, since their dynamics are different. Following the Modigliani-Miller theorem, higher capital requirements will not change (steady state) total funding costs under some severe assumptions. From the discussion of theoretical papers can be concluded that this theorem does not hold on banking in its pure form, although it is useful to identify frictions and distortions. The theoretical analysis emerges two distortions, namely the tax shield and implicit government guarantee. These public policies have a significant damping effect on the funding costs of bank debt and implicitly subsidize debt. Given the fact that in the current situation bank debt is subsidized, then replacing this debt with more equity capital reduces the ability of banks to exploit the implicit subsidies in the new equilibrium. Second, the self-fulfilling beliefs of banks that capital is expensive and the ROE is fixed in a new steady state are fallacious and incorrect. Theoretical insights show that having more equity capital distributes risk and must lower the required return on equity. Holding a bank share in the new equilibrium could be an attractive asset class if risk is distributed and all banks are better capitalized so that they internalize losses and depreciations. Meantime, raising more equity capital entails debt overhang and information asymmetry problems, especially if banks are poorly capitalized. The dilutive effect of an equity capital issuance creates incentives for bank management and existing shareholders to resist reductions in leverage that make existing debt safer. Banks have no importance in higher equity capital ratios, due to this debt overhang. The empirical studies examined in chapter three mainly focus on the cost side of higher capital requirements and hold the ROE fixed. This is not consistent with the theoretical insights discussed in chapter two. The outcomes of these studies over-estimate the increases of funding costs and neglect some beneficial consequences of higher capital requirements, such as lower required returns on equity and the reduction of distortions and inefficiencies. These studies also focus on private costs and do not take into account the social benefits of a better-capitalized banking system. Most importantly, a large part of the estimated rise in funding costs is caused by the loss of subsidized debt. Having more equity capital reduces the ability of banks to obtain the benefits of the tax shield and implicit government guarantees. Without these distortions, the transition towards a

46

better-capitalized banking system would be easier. Reforms of the corporate tax system and the government guarantee policy should complement higher capital requirements. The second part of this thesis focuses on these two distortions and reforms. Chapter four shows that the implicit subsidy that is created by the deductibility of interest expenses favors debt financing significantly. As leverage and interest rates increases, so does the distortive effect of the tax shield. This allows investors of leveraged banks to capture more revenue due to lower tax expenses. Calculations of the Dutch situation confirm that high-leveraged banks indeed exploit this implicit subsidy relatively more than their better-capitalized competitors. This negative externality incentivizes banks to prefer debt financing, while on the other hand more equity capital needs to be acquired. The challenge of reforming the corporate tax system is to remain total tax expenses more or less unchanged and to shift the incentive from debt financing to equity financing. Therefore, the deductibility of interest expenses should be maximized or capped, while net interest income could be less taxed. Such a reform needs to be set internationally. The distortive effect of the implicit government guarantee lowers funding costs of bank debt, as explained in chapter five. In the presence of implicit government guarantees, not all inefficiencies of high leverage are reflected in the costs of bank debt funding. The guarantee also exacerbates the debt overhang problem, because debt holders have fewer incentives to address excessive risk-taking and high leverage ratios. The implicit government guarantees can be significantly reduced if the banking system is better capitalized and able to internalize losses and depreciations. Estimations of the Dutch implicit subsidy show that the impact of the guarantee significantly increased during and after the financial crisis. The calculations demonstrate that due to a lower market confidence in banks and higher levels of uncertainty, the advantages of the implicit government guarantee on funding costs increased, especially for high-leveraged banks with lower credit ratings. To reduce the need and impact of an implicit government guarantee, the banking system must be recapitalized through intervention by the government and/or regulator. This could be done by imposing a contingent capital (CoCo) requirement. CoCo is a form of debt that automatically converts to equity if a bank faces too many losses. If the amount of CoCos is large and the conversion rate dilutive, banks will have incentives to prevent conversion. Hence, banks will have interest to acquire new equity capital timely. Due to the large size of CoCos, the likelihood of a bail out reduces and the implicit government guarantee is of less importance. Concluding, equity capital is not expensive, but bank debt is made cheap. Therefore, Basel III should be complemented with tax policy reforms and recapitalization of the banking system with the use of a contingent capital (CoCo) requirement.

47

List of Abbreviations

BCBS BHC BIS CAPM CEO CoCo DNB ECB EURIBOR ESM FDIC Fed FSA GDP IIF IMF LIBOR MAG MMMF NPV OECD Repo ROE RWA SIFI TARP TBTF TITF WACC

Basel Committee on Banking Supervision Bank Holding Company Bank for International Settlements Capital Asset Pricing Model Chief Executive Officer Contingent Convertible De Nederlandsche Bank (NL) European Central Bank (EU) EURo InterBank Offered Rate European Stability Mechanism Federal Deposit Insurance Corporation Federal Reserve System (US) Financial Services Authority (UK) Gross Domestic Product Institute of International Finance International Monetary Fund London Interbank Offered Rate Macroeconomic Assessment Group Money Market Mutual Fund Net Present Value Organization for Economic Co-operation and Development Repurchase agreement Return On Equity Risk Weighted Assets Systemically Important Financial Institution Troubled Asset Relief Program Too Big To Fail Too Important To Fail Weighted Average Cost of Capital

Note: capital = equity capital, unless explicitly mentioned

48

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Brei, M., Gambacorta, L., Von Peter, G. (2011) Rescue Packages and Bank Lending, BIS Working Paper, no. 357 Calomiris, C., Herring, R. (2011) Why and How to Design a Contingent Convertible Debt Requirement, Financial Institutions Center Working Paper No. 11-41, University of Pennsylvania Wharton School Cosimano, T., Hakura, D. (2011) Bank Behavior in Response to Basel III: A CrossCountry Analysis, IMF Working Paper, no.119 Diamond, D., Dybvig, P. (1983) Bank Runs, Deposit Insurance and Liquidity, Journal of Political Economy, no. 91, pp. 401-419 De Nicolo, G., Gamba, A., Lucchetta, M. (2012) Capital Regulation, Liquidity Requirements and Taxation in a Dynamic Model of Banking, Discussion Paper no. 10, Deutsche Bundesbank Fatica, S., Hemmelgarn, T., Nicodme, G. (2012) The Debt-Equity Tax Bias: Consequences and Solutions, European Commission Working Paper no. 33 Frenkel, M., Rudolf, M. (2010) The Implications of Introducing an Additional Regulatory Constraint on Banks Business Activities in the Form of a Leverage Ratio, working paper Gambacorta, L., Mistrulli, P. (2004) Does Bank Capital Affect Lending Behavior? Journal of Financial Intermediation, vol. 13, pp. 436-457 Gorton, G. (2010) Slapped By the Invisible Hand: The Panic of 2007, Oxford University Press Gorton, G., Metrick, A. (2010) Securitized Banking and the Run on Repo, forthcoming, Journal of Financial Economics Gorton, G., Metrick, A. (2010) Regulating the Shadow Banking System, Brooking Papers on Economic Activity, Q3-2010, pp. 261-312 Gorton, G., Lewellen, S., Metrick, A. (2011) The Cost of Bank Capital: Thinking Beyond Modigliani and Miller, working paper Gorton, G., Ordonez, G. (2012) Collateral Crises, NBER Working Paper, No. 17771 Hellwig, M. (2010) Capital Regulation after the Crisis: Business as Usual? Working paper

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Other References, Sources and Data Annual reports and form 20-F of ABN AMRO 1999-2012 via www.abnamro.nl, www.shareholder.com and www.sec.gov Annual reports and form 20-F of ING 1996-2012 via www.ing.com and www.sec.gov Annual reports of Rabobank 2000-2012 via www.rabobank.nl and Rabobank Investor Relations via IR@rabobank.com

Annual report DNB (2011) and www.dnb.nl Bloomberg Fixed Income Database Interim report Committee Van Dijkhuizen (2012) Lecture by Miles, D., Optimal Bank Capital, Stanford Finance Forum, June 2011 via www.youtube.com Lecture by Admati et al., Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive, Stanford Finance Forum, June 2011 via www.youtube.com Ministry of Finance, Corporate tax rates 1996-2012, via www.rijksoverheid.nl The Economist, Strength in Numbers: How Much Capital Did Banks Opt to Hold When They Had the Choice?, November 10th 2012 The Financial Times, More Capital Will Not Stop the Next Crisis, R. Rajan, October 1st 2009 The Region, Federal Reserve Bank of Minneapolis, Interview with Gary Gorton, December 2010, pp. 14-29 The Wall Street Journal, Running on Empty, J. H. Cochrane, March 2nd 2013

** Several informal meetings with banks, accountancy and consultancy firms **

53

Appendices 1. Data Leverage Calculation

38

38

Sources: annual reports, 20-F form (SEC)

54

2.

Key Interest Rates39

3.

Data Tax Shield40

[EXCEL INPUT ON THE NEXT PAGE]

Source: LIBOR via Fed www.research.stlouisfed.org and others via DNB www.statistics.dnb.nl The different corporate tax rates among countries and jurisdictions are neglected because the data that is needed for allocation of interest payments is confidential and not publically available.
40

39

55

56

4.

Net Interest and Fee Income41

ABN AMRO
15.000 10.000 5.000 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Net fee income Net interest income

Rabobank
15.000 10.000 5.000 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Net fee income Net interest income

20.000 15.000

ING
Net fee income

10.000 5.000 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Net interest income

41

Sources: annual reports, 20-F form (SEC)

57

5.

Data and Calculations Implicit Government Guarantee42 Aaa Aa1 36 88 77 36 46 29 20 19 23 135 82 53 45 22 Aa2 41 94 82 39 51 34 25 23 26 147 109 59 50 27 Aa3 48 99 86 43 57 46 34 28 32 156 130 65 57 32 A1 55 106 98 55 70 56 38 34 38 163 156 74 64 42 A2 65 113 112 66 79 67 46 41 44 168 182 91 75 51 A3 89 137 134 86 94 81 54 48 53 176 213 116 99 73 Baa1 143 182 203 149 146 145 110 98 100 217 345 267 239 193 Baa2 172 241 400 297 243 303 229 143 121 265 411 333 306 260 Baa3 210 282 491 394 326 383 345 261 243 364 508 431 403 358

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

31 68 65 22 39 20 14 15 21 126 65 47 41 18

of US Corporate Bonds US Treasury Bills Source: Bloomberg (Average Credit Spreads 1-year versus 1-year in Basis Points)

2,5 2 1,5 1 0,5 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Credit Rating Notches (difference between stand-alone and supported), source: Moodys

Notches

42

Sources: annual reports, form 20-f, Moodys (2011, 2012), Bloomberg

58

 14.000 12.000 10.000 8.000 6.000 4.000 2.000 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Implicit Subsidy (High) 1999-2012, sources: annual reports, Moodys and Bloomberg

ING

ABN AMRO

Rabobank

2.500

2.000 ABN AMRO ING 1.000 Rabobank 500

1.500

0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Implicit Subsidy (Low) 1999-2012, sources: annual reports, Moodys and Bloomberg

59

60

61

6.

Capital Ratios Graphs

Source: Kashyap, Stein, Hanson (2010)

62

7.

Bank Lending Spreads Graph

Bank Lending Spreads, USA and EU 1982-2009, source: King, M. (2010) BIS Working Paper 324

63