The True Cost of (Equity) Capital

I know it's nice to discount any complaint or warning issues by bankers that some new regulation will negatively impact the economy, but I think when it comes to concerns around increasing (equity) capital requirements, they are correct. We should increase capital requirements anyway.

Kwak discounts the bankers' concerns with a number of assertions which are, factually, not true:

Some of the arguments against higher capital requirements are simply incoherent, like the idea that banks would be forced to set aside capital instead of lending it...

Some contradict basic principles of corporate finance, like the idea that adding more equity capital increases banks’ cost of funding.* Yes, equity is usually more expensive than debt (meaning that investors demand a higher expected rate of return) because it is riskier (the range of possible outcomes is greater). But as you add equity, both the debt and the equity become less risky (since the firm is less leveraged), which reduces the cost of debt and the cost of equity...

In the real world, debt has a tax advantage (interest on debt is tax-deductible, while cash that is paid to shareholders or reinvested in operations is not), so increasing debt can reduce the overall cost of financing. But that’s a government subsidy...

I'll be gentle and not cite the part where he brings up Modigliani-Miller. Kwak is likely familiar with some corp fin, but is not well versed in bank operations or regulation. A banks ability to lend is primarily constrained by capital requirements (not reserve requirements as many thing) which means there is a limit to how many loans it can extend, and the riskiness of those loans, based on how much equity it has. All else equal, the more a bank lends, and the higher an interest rate in can charge on those loans, the more money it makes.

Therefore, higher capital requirements limit how much a bank can lend, which impacts its ability to make money, and also causes economic harm to the extent that less bank lending is harmful to the non-bank economy.

Some important additional elements: We want bank lending to be prudent, which means putting private capital in first loss position against bad loans. The equity that investors put into banks is exactly the capital which should be in first loss position, so having more of it is not a bad idea as it will be able to absorb more loan writeoffs before the bank needs to go to the Government for a hand out.

Beyond that, the system can still be gamed by mispricing risk on the asset side -- if you can classify a risk asset as a safe one (as the banking system did with mortgages) you can end up undercapitalized on a risk adjust basis even with larger capital requirements. Higher thresholds deal with this in a crude way, but I'm not sure what better tools there are to model risk more accurately and make sure that this sort of covert leveraging is not allowed. Better to accept it's a black box and forbid securitization -- keep loans on the books of the originator and make those who invest in the originator have their necks on the line for performance.