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STANFORD Graduate School of Business: Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation – Why Bank Equity is Not Expensive

Abstract

We examine the pervasive view that “equity is expensive,” which leads to claims that high capital requirements are costly and would affect credit markets adversely. We find that arguments made to support this view are either fallacious, irrelevant, or very weak. For example, the return on equity contains a risk premium that must go down if banks have more equity. It is thus incorrect to assume that the required return on equity remains fixed as capital requirements increase. It is also incorrect to translate higher taxes paid by banks to a social cost. Policies that subsidize debt and indirectly penalize equity through taxes and implicit guarantees are distortive.

Any desirable public subsidies to banks’ activities should be given directly and not in ways that encourage leverage. Finally, suggestions that high leverage serves a necessary disciplining role are based on inadequate theory lacking empirical support. We conclude that bank equity is not socially expensive, and that high leverage is not necessary for banks to perform all their socially valuable functions, including lending, taking deposits and issuing money-like securities. To the contrary, better capitalized banks suffer fewerdistortions in lending decisions and would perform better. The fact that banks choose highleverage does not imply that this is socially optimal, and, viewed from an ex anteperspective, high leverage may not even be privately optimal for banks.

Setting equity requirements significantly higher than the levels currently proposed wouldentail large social benefits and minimal, if any, social costs. Approaches based on equitydominate alternatives, including contingent capital. To achieve better capitalization quickly and efficiently and prevent disruption to lending, regulators must actively control equity payouts and issuance. If remaining challenges are addressed, capital regulation can be a powerful tool for enhancing the role of banks in the economy.

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