Wednesday, November 4, 2009

Bank capital structure

The Economist has a nice article applying Modigliani and Miller's capital structure theory to the capital structure of banks. M&M said that in the absence of taxes and bankruptcy costs capital structure should not matter.

But banks are different - because large banks are too big to fail, the presence of bankruptcy costs don't matter. Furthermore, as banks benefit from very low debt costs (due to deposit insurance), their optimal capital structure is frequently very high.

In reality, large banks are more risky because of the risk they transfer to outsiders (tax payers) and therefore they should hold more capital than equivalent banks of a smaller size. But of course the banks don't want to hold more equity capital as equity is expensive relative to deposits.

The article is well worth a read.