Letter: Capital without deposits is novel bank funding model

In “Banks will beat Basel III for all the wrong reasons” (Opinion, July 1) Todd H Baker argued that banks should be required to fund themselves with more capital. His argument is premised on the 1958 theorem of Franco Modigliani and Merton Miller, which holds that the total value of an enterprise should be unaffected by how it is financed (in a world with no taxes and perfect information). However, quite strangely for a believer in the theorem, he went on to speculate that banks oppose higher capital because if they were funded with more capital their market value would be lower, perhaps by half.

A true believer in Modigliani and Miller’s theorem would conclude that
a bank can be funded with no deposits and all capital with no consequences for its private and social value. The rest of us, perhaps including Baker, need to confront the difficult question of what capital ratio is optimal. No one doubts that capital has the benefit of protecting banks against unexpected losses, but what is the optimal amount. When seeking to avoid the headaches created by bank failures, one aspirin helps, two helps more, but that does not mean you should take the whole bottle.

Moreover, if Modigliani-Miller is a reasonably accurate depiction of reality, then the share price of a bank should be largely unaffected if the bank, say, issues equity and uses it to buy back debt. If bank stocks would fall by as much as Professor Baker speculates if they were funded with more capital, that would be a strong indication that equity financing is expensive, so financing a bank with more of it results in more expensive credit and less economic activity.

As it happens, that trade-off between greater safety and reduced economic activity is precisely how the Basel Committee on Banking Supervision estimated the optimal proportion of capital financing when calibrating Basel III, and how the Bank of England, IMF, and Federal Reserve Board subsequently developed their estimates of the optimal proportion. While these estimates take hard work to develop and are necessarily imprecise, at least they took a stab at it.

Bill Nelson
Executive Vice President and Chief Economist, Bank Policy Institute, Washington, DC, US