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Are Banks Special?

Author

Listed:
  • Michel Crouhy

    () (Head of Research & Development, Natixis, Paris, France)

  • Dan Galai

    (The School of Business Administration, The Hebrew University, Jerusalem, Israel3The Sarnat School of Management, Or Yehuda, Israel)

Abstract

This paper addresses the following question: Are banks special firms that can achieve their goals only with high leverage, above and beyond what is considered acceptable for industrial corporations?This question is related to the issue of the cost of capital and how it is affected by leverage. If we accept the Modigliani–Miller (M&M) theorem (1958), then the capital structure is irrelevant for both the cost of capital and the value of the bank. Specifically, the M&M hypothesis argues that higher levels of equity capital reduce bank leverage and risk, leading to an offsetting decline in banks’ cost of equity capital. Hence, we ask the question whether banks are special firms such that M&M theorem does not apply to banks.We show that M&M propositions cannot be applied for banks primarily because of explicit guarantees and subsidies that provide incentives for increasing leverage. Then, some of the risk faced by the bank is transferred at no cost to the providers of these guarantees and subsidies, giving banks the incentive to increase leverage as much as they can. We show that under perfect market conditions, when risk is fairly priced, this opportunity vanishes.

Suggested Citation

  • Michel Crouhy & Dan Galai, 2018. "Are Banks Special?," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 8(04), pages 1-19, December.
  • Handle: RePEc:wsi:qjfxxx:v:08:y:2018:i:04:n:s2010139218400049
    DOI: 10.1142/S2010139218400049
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    References listed on IDEAS

    as
    1. Dan Galai, 2006. "The "Ostrich Effect" and the Relationship between the Liquidity and the Yields of Financial Assets," The Journal of Business, University of Chicago Press, vol. 79(5), pages 2741-2759, September.
    2. Crouhy, Michel & Galai, Dan, 1986. "An economic assessment of capital requirements in the banking industry," Journal of Banking & Finance, Elsevier, vol. 10(2), pages 231-241, June.
    3. Admati, Anat R., 2015. "Rethinking Financial Regulation: How Confusions Have Prevented Progress," Research Papers 3291, Stanford University, Graduate School of Business.
    4. Reint Gropp & Florian Heider, 2010. "The Determinants of Bank Capital Structure," Review of Finance, European Finance Association, vol. 14(4), pages 587-622.
    5. Charles W. Calomiris & Richard J. Herring, 2013. "How to Design a Contingent Convertible Debt Requirement That Helps Solve Our Too-Big-to-Fail Problem," Journal of Applied Corporate Finance, Morgan Stanley, vol. 25(2), pages 39-62, June.
    6. Tümer Kapan & Camelia Minoiu, 2013. "Balance Sheet Strength and Bank Lending During the Global Financial Crisis," IMF Working Papers 13/102, International Monetary Fund.
    7. Dermine, Jean & Lajeri, Fatma, 2001. "Credit risk and the deposit insurance premium: a note," Journal of Economics and Business, Elsevier, vol. 53(5), pages 497-508.
    8. Anat Admati & Martin Hellwig, 2013. "The Bankers' New Clothes: What's Wrong with Banking and What to Do about It," Economics Books, Princeton University Press, edition 1, number 9929.
    9. Crouhy, Michel & Galai, Dan, 1991. "A contingent claim analysis of a regulated depository institution," Journal of Banking & Finance, Elsevier, vol. 15(1), pages 73-90, February.
    10. Adrian Blundell-Wignall & Paul Atkinson, 2012. "Deleveraging, Traditional versus Capital Markets Banking and the Urgent Need to Separate and Recapitalise G-SIFI Banks," OECD Journal: Financial Market Trends, OECD Publishing, vol. 2012(1), pages 7-44.
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