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Do Strict Capital Requirements Raise the Cost of Capital? Banking Regulation and the Low Risk Anomaly

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  • Malcolm Baker
  • Jeffrey Wurgler

Abstract

Minimum capital requirements are a central tool of banking regulation. Setting them balances a number of factors, including any effects on the cost of capital and in turn the rates available to borrowers. Standard theory predicts that, in perfect and efficient capital markets, reducing banks' leverage reduces the risk and cost of equity but leaves the overall weighted average cost of capital unchanged. We test these two predictions using U.S. data. We confirm that the equity of better-capitalized banks has lower systematic risk (beta) and lower idiosyncratic risk. However, over the last 40 years, lower risk banks have higher stock returns on a risk-adjusted or even a raw basis, consistent with a stock market anomaly previously documented in other samples. The size of the low risk anomaly within banks suggests that the cost of capital effects of capital requirements may be considerable. Assuming competitive lending markets, banks' low asset betas implied an average risk premium of only 40 basis points above Treasury yields in our sample period; a calibration suggests that a ten percentage-point increase in Tier 1 capital to risk-weighted assets may have increased this to between 100 and 130 basis points per year. In summary, the low risk anomaly in the stock market produces a potentially significant cost of capital requirements.

Suggested Citation

  • Malcolm Baker & Jeffrey Wurgler, 2013. "Do Strict Capital Requirements Raise the Cost of Capital? Banking Regulation and the Low Risk Anomaly," NBER Working Papers 19018, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:19018
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    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. Making Finance Safe
      by Steve Cecchetti and Kim Schoenholtz in Money, Banking and Financial Markets on 2014-10-06 17:30:15

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    Cited by:

    1. Sophia Kassidova, 2016. "Capital Change and the Cost of Equity: Evidence from Bulgarian Banks. Is there a Modigliani-Miller offset?," International Journal of Economics & Business Administration (IJEBA), International Journal of Economics & Business Administration (IJEBA), vol. 0(3), pages 47-59.
    2. Belkhir, Mohamed & Ben Naceur, Sami & Chami, Ralph & Samet, Anis, 2021. "Bank capital and the cost of equity," Journal of Financial Stability, Elsevier, vol. 53(C).
    3. Barth, James R. & Miller, Stephen Matteo, 2018. "Benefits and costs of a higher bank “leverage ratio”," Journal of Financial Stability, Elsevier, vol. 38(C), pages 37-52.
    4. Budnik, Katarzyna & Affinito, Massimiliano & Barbic, Gaia & Ben Hadj, Saiffedine & Chretien, Edouard & Dewachter, Hans & Gonzalez, Clara Isabel & Hu, Jenny & Jantunen, Lauri & Jimborean, Ramona & Mann, 2019. "The benefits and costs of adjusting bank capitalisation: evidence from euro area countries," Working Paper Series 2261, European Central Bank.
    5. Stanley Fischer, 2017. "Housing and Financial Stability : a speech at the DNB-Riksbank Macroprudential Conference Series, Amsterdam, Netherlands, June 20, 2017," Speech 956, Board of Governors of the Federal Reserve System (U.S.).
    6. Beltratti, Andrea & Paladino, Giovanna, 2015. "Bank leverage and profitability: Evidence from a sample of international banks," Review of Financial Economics, Elsevier, vol. 27(C), pages 46-57.
    7. Leone Leonida & Eleonora Muzzupappa, 2018. "Do Basel Accords influence competition in the banking industry? A comparative analysis of Germany and the UK," Journal of Banking Regulation, Palgrave Macmillan, vol. 19(1), pages 64-72, January.
    8. Matthew Plosser, 2014. "Bank heterogeneity and capital allocation: evidence from \\"fracking\\" shocks," Staff Reports 693, Federal Reserve Bank of New York.
    9. Maryam Hasannasab & Dimitris Margaritis & Christos Staikouras, 2019. "The financial crisis and the shadow price of bank capital," Annals of Operations Research, Springer, vol. 282(1), pages 131-154, November.
    10. Brooke, Martin & Bush, Oliver & Edwards, Robert & Ellis, Jas & Francis, Bill & Harimohan, Rashmi & Neiss, Katharine & Siegert, Caspar, 2015. "Financial Stability Paper No. 35: Measuring the macroeconomic costs and benefits of higher UK bank capital requirements -," Bank of England Financial Stability Papers 35, Bank of England.
    11. Bouwman, Christa H. S., 2013. "Liquidity: How Banks Create It and How It Should Be Regulated," Working Papers 13-32, University of Pennsylvania, Wharton School, Weiss Center.
    12. Petr Pavlík, 2017. "Financial theory approach to the investigation of the impact of Basel III capital adequacy on commercial banks [Vědecké metody zkoumání dopadu kapitálové regulace obchodních bank]," Český finanční a účetní časopis, Prague University of Economics and Business, vol. 2017(4), pages 41-56.
    13. Tetiana Davydiuk, 2017. "Dynamic Bank Capital Requirements," 2017 Meeting Papers 1328, Society for Economic Dynamics.
    14. Alexander Schäfer & Isabel Schnabel & Beatrice Weder di Mauro, 2016. "Financial Sector Reform after the Subprime Crisis: Has Anything Happened?," Review of Finance, European Finance Association, vol. 20(1), pages 77-125.

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    More about this item

    JEL classification:

    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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