Are Banks Firms? The Modigliani-Miller Theorem Revisited

Abstract

The capital structure of banks has become the focus of an extended debate among policy-makers, regulators and academics. The seminal Modigliani-Miller (1958) theorem is seen as supportive of regulators' drive to require higher equity capital to banks. This raises the question on to what extent does Modigliani-Miller theorem hold for banks. This article brings a new insight of the Modigliani-Miller theorem by considering the implicit government guarantee offered to banks. Our main theorem shows that a bank can no longer be considered as a classical firm and will favor leverage instead of equity.