Impact of Higher Capital Requirements on Bank Funding Costs: Australian Evidence

Abstract

This study examines the long-run cost implications for banks of funding more of their assets with equity capital, in an economy with a strong dependence on bank-intermediated financing and a highly concentrated banking industry. Despite domestic conditions that are likely to heighten expectations of government support for banks, we find robust evidence that equity investors are willing to accept a lower risk premium for investing in less leveraged banks. The relationship between the equity risk premium and leverage is not significantly affected by bank size. However, we find that equity pricing became more responsive to bank leverage after the 2007-2009 financial crisis. The impact of additional equity capital on the overall cost of bank funding is small (in the order of 0-3 basis points annually for each 1-percentage-point increase in the ratio of equity capital to risk-adjusted assets).