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Why is equity capital expensive for opaque banks?

Bank managers often claim that equity is expensive relative to debt, which contradicts the Modigliani-Miller irrelevance theorem. This paper combines dividend signalling theories and the Diamond-Dybvig bank run model. An opaque bank must signal its solvency by paying high and stable dividends in order to keep depositors tranquil. This signalling may require costly liquidations if the return on assets has been poor, but not paying the dividend might cause panic and trigger a run on the bank. The more equity has been issued, the more liquidations are needed during bad times to pay the expected dividend to each share.

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Paper provided by Bank of Finland in its series Research Discussion Papers with number 4/2012.

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Length: 26 pages
Date of creation: 26 Jan 2012
Date of revision:
Handle: RePEc:hhs:bofrdp:2012_004
Contact details of provider: Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
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