Bank Capital and the Modigliani-Miller Theorem When Loans Create Deposits

Seminar Aim

The seminar will examine the question of optimal bank capital structure and the applicability of the Modigliani-Miller theorem when loans create deposits using a dataset of US commercial banks.

Event Abstract

How much capital should banks hold? This is a question that has sparked a lot of controversy, especially after the 2008 crisis, amongst regulators, bankers and academics. This paper argues that the current debate on bank capital structure is grounded on false premises. Banks should not be treated as intermediaries of loanable funds in order to determine optimal bank capital structure. In the real world banks create deposits through lending. The Modigliani–Miller analysis cannot be applied to banks because when lending creates deposits the asset side of banks varies together with the liability side and equity behaves more like a sticky variable. In this setting, procyclical high leverage in the banking sector emerges almost mechanically. When banks increase equity through new issues or retained earnings they contract deposits by an equal amount. An increase in capital requirements is desirable to the extent that benefits from more resilient banks outweigh the costs from reducing the supply of claims that have the form of bank deposits and carry a convenience yield for liquidity and safeness. The arguments of the paper are verified in an empirical study of US commercial banks.

Booking

This is an open event; there is no need to book. Please feel free to attend and bring your colleagues, classmates and friends.