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Do Strict Capital Requirements Raise the Cost of Capital? Bank Regulation, Capital Structure, and the Low Risk Anomaly

Last Updated on 10 February, 2024 by Rejaul Karim

Do Strict Capital Requirements Raise the Cost of Capital? Bank Regulation and the Low Risk Anomaly” presented by Malcolm P. Baker and Jeffrey Wurgler unveils a thought-provoking inquiry into the intricate interaction between bank regulation and the low risk anomaly.

The traditional tenets of capital structure theory, rooted in frictionless and efficient markets, forecast that a reduction in banks’ leverage should diminish the risk and cost of equity, yet not alter the overall weighted average cost of capital. This study rigorously tests these predictions, demonstrating that the equity of better-capitalized banks indeed carries lower beta and idiosyncratic risk.
However, a perplexing pattern emerges over the last four decades, as lower-risk banks demonstrate higher stock returns, aligning with a stock market anomaly previously observed in different samples. The implications of this low risk anomaly within banks indicate substantial capital cost effects, meriting consideration in policy dialogues.

Notably, the study’s calibration underscores that a compelling increase in Tier 1 capital to risk-weighted assets significantly amplifies banks’ average risk premium over Treasury yields, potentially leading to comparable elevations in borrowing rates.

Abstract Of Paper

Traditional capital structure theory in frictionless and efficient markets predicts that reducing banks’ leverage reduces the risk and cost of equity but does not change the overall weighted average cost of capital (and thus the rates for borrowers). We test these two predictions. We confirm that the equity of better-capitalized banks has lower beta and idiosyncratic risk. However, over the last 40 years, lower risk banks have higher stock returns on a risk-adjusted or even a raw basis, consistent with a stock market anomaly previously documented in other samples. The size of the low risk anomaly within banks suggests that the cost of capital effects of capital requirements is large enough to be relevant to policy discussions. A calibration assuming competitive lending markets suggests that a binding ten percentage-point increase in Tier 1 capital to risk-weighted assets more than doubles banks’ average risk premium over Treasury yields, from 40 to between 100 and 130 basis points per year, and presumably raises rates for borrowers to a similar extent.

Original paper – Download PDF

Here you can download the PDF and original paper of Do Strict Capital Requirements Raise the Cost of Capital? Bank Regulation, Capital Structure, and the Low Risk Anomaly.

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Author

Malcolm P. Baker
Harvard Business School; National Bureau of Economic Research (NBER)

Jeffrey Wurgler
NYU Stern School of Business; National Bureau of Economic Research (NBER)

Conclusion

In the exploration of “Do Strict Capital Requirements Raise the Cost of Capital? Bank Regulation and the Low Risk Anomaly,” Malcolm P. Baker and Jeffrey Wurgler illuminate compelling findings that resonate with the intricacies of bank regulation and the anomalies observed within the risk paradigm.

The traditional projections from capital structure theory, centered on frictionless and efficient markets, are rigorously tested, affirming the foreseen reduction in risk and cost of equity in better-capitalized banks. However, the captivating revelation of the last 40 years lies in the unmistakable pattern where lower-risk banks exhibit higher stock returns, echoing the stock market anomaly seen in diverse samples.

The profound implications arising from the low risk anomaly within banks underscore its substantial relevance to policy deliberations. In particular, the calibration reveals that a notable increase in Tier 1 capital to risk-weighted assets significantly amplifies banks’ average risk premium over Treasury yields, indicating its probable influence on borrowing rates.

These conclusions urge a closer examination of the complex dynamics at play within banks’ capital structures and their interactions with regulatory frameworks.

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