Bank Capital Regulation, the Modigliani-Miller Theorem, and the Winstar Litigations

Olivier Blanchard’s Rethinking Macroeconomic Policy notes the following under Finanical Regulation:

I am struck by the level of uncertainty and disagreement about the effects of capital ratios on funding costs, and thus on lending. Reasonable people, such as Martin Hellwig and Anat Admati, argue that we are not so far from the Modigliani-Miller world, and banks can afford substantially higher capital ratios. Others, and not only bankers, argue that such ratios would instead destroy the banking industry.

This reference to Modigliani-Miller intrigued me because of certain discussions of the Winstar litigations, which we’ll note below. Martin Hellwig and Anat Admati co-authored with Peter M. DeMarzo and Paul Pfleiderer Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive. While I highly recommend that you should read the entire paper, let me provide the references to the Modigliani-Miller theorem:

One of the fundamental results of corporate finance (Modigliani and Miller, 1958) states that, absent additional considerations such as those involving tax advantages or public subsidies to debt, increases in amount of financing done through equity simply re-distributes the total risk that must be borne by investors in the bank, i.e., the holders of debt and equity and any other securities that the bank may issue. The total risk itself is given by the risks that are inherent in the bank’s asset returns. In a market in which risk is priced correctly, an increase in the amount of equity financing lowers the required return on equity in a way that, absent subsidies to bank debt and other frictions, would leave the total funding costs of the bank the same. The Modigliani-Miller analysis is often dismissed on the grounds that the underlying assumptions are highly restrictive and, moreover, that it does not apply to banks, which get much of their funding in the form of deposits. The essence of this result, however, is that in the absence of frictions and distortions, changes in the way in which any firm funds itself does not change either the investment opportunities or the overall funding costs determined in the market by final investors. The one essential assumption is that investors are able to price securities in accordance with their contribution to portfolio risk, understanding that equity is less risky when a firm has less leverage i.e., funds itself with less debt.

The authors use this result to discredit one of the common arguments made against significantly increasing equity requirements:

Increased equity requirements would increase banks’ funding costs because equity requires a higher return than debt. This argument is fallacious, because the required return on equity, which includes a risk premium, must decline when more equity is used. Any argument or analysis that holds fixed the required return on equity when evaluating changes in equity capital requirements is fundamentally flawed.

So what were the Winstar litigations? United States v. Winstar Corp. was a Supreme Court decision that the Federal government breached certain contractual obligations when the Bush41 administration chose to restore capital adequacy requirements in the aftermath of the savings-and-loan crisis. Winstar cases are still in litigation with enormous purported damages being suggested by the attorneys for the financial institutions such as Winstar. Some of the arguments put forth by these attorneys are akin to what Blanchard dubbed the bankers argument that capital adequacy rules “would instead destroy the banking industry”. The Federal government as defendant in the Winstar litigations hired expert witnesses to argue for lower damages, which seems to be a reasonable proposition given the above discussion of how the Modigliani-Miller Theorem applies to the financial sector. But leave it to the bankers and their attorneys to find any means possible for extracting the rents from either the public and taxpayers – even if they have to hire prostitutes dressed up as expert witnesses.