Saturday, January 29, 2011

Higher Bank Capital Amounts Comment

A comment I posted on The Wall Street Journal article, "Number of the Week: Banks Should Hold More Capital" by Mark Whitehouse:
There is no contradiction. Modigliani and Miller wrote about an ideal situation with no bankruptcy (insolvency) and no taxes. It is a solid foundation to build upon and incorporate real world dynamics.

M-M did not incorporate into their research government backed deposit insurance and too big too fail government intervention. Government intervention through deposit insurance and too big to fail undoes much of Modigliani and Millers arguments. Their main arguments rely on market pricing and risk adjusted pricing of equity and debt. Government intervention, in any sector or industry including banking, interferes with risk adjusted pricing of equity and debt.

Fifty years ago, researchers realized that the addition of tax deductibility of interest expense would push firms to increase their debt levels. Similarly, the increasing risk of bankruptcy with increasing debt levels would push firms away from more debt financing. Whether the two forces offset each other or one dominates if at all is an open research question and much has been written on the topic.

Even at 52 percent capital, banks will go insolvent because banks face not only a valuation insolvency risk, debt value greater than asset value, they face liquidity and cash flow insolvency risk.

A bank with 52 percent capital can face a 'run on the bank' and if its loans and investments are illiquid, cannot be sold quickly in the market and converted into cash at face (par) value prices, it will not have adequate funds to pay withdrawals. If too many depositors withdraw their funds, the bank will face a run, and the government will step in to help with needed funds, or operate the bank, or force a takeover or close the bank and pay depositors from the insurance fund.

Banks face several different forms of insolvency risks and high capital amounts do not solve all the potential solvency problems banks face.

Regulators like capital because it is computable and measurable by a formula, easy to observe and fill in on a form, can be set at a precise level and avoids the appearance that the government acted arbitrarily against a particular bank. High capital amounts are not the end to future bank problems, and a low amount of capital amount is not the cause of bank problems.

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