On the non-neutrality of the financing policy and the capital regulation of banking firms

Abstract

Purpose The paper aims to investigate whether the value of banks is affected by their financing policies. Higher capital requirements have been invoked by exploiting a renewed edition of the Modigliani–Miller (M&M) theorem. This paper shows the limits of this claim by highlighting that the general statement that “bank equity is not expensive” can be misleading. The authors argue that market prices should play an important role in bank supervision. Expectations of future profits in prices supply timely information on the viability of a bank. Design/methodology/approach The authors use the Merton model to show the inapplicability of M&M theorem to banks. The long-run viability of a bank is analyzed with a dividend discount model which allows to compare a bank’s long-term profitability with its overall cost of capital implicit in market prices. Findings The authors show that the M&M framework cannot be applied to banks neither ex-ante nor ex-post. Ex-ante the authors focus on government guarantees, ex-post they emphasize the risk-shifting phenomena that may increase the overall risk of the bank. The authors show that a bank’s stability cannot be achieved if the market expectations of its future profits stay below the cost of funding. Research limitations/implications The authors use simple analytical models. In a future study, some key peculiarities of banks, such as the monetary nature of deposits, should be analytically modelled. Practical implications The paper contributes to the debate on capital regulation on the level of capital requirements and the instruments to assess the viability/stability of banks. Originality/value This paper uses simple models to assess analytically the key issues in the debate on banks’ capital regulation.