Here is another paper for anyone interested in the optimal bank capital structure debate. It is a Bank of England Staff Working Paper titled “Bank funding costs and capital structure” by Andrew Gimber and Aniruddha Rajan.
The authors summarise their paper as follows:
“If bail-in is credible, risk premia on bank securities should decrease as funding sources junior to and alongside them in the creditor hierarchy increase. Other things equal, we find that when banks have more equity and less subordinated debt they have lower risk premia on both. When banks have more subordinated and less senior unsecured debt, senior unsecured risk premia are lower. For percentage point changes to an average balance sheet, these reductions would offset about two thirds of the higher cost of equity relative to subordinated debt and one third of the spread between subordinated and senior unsecured debt.”Abstract
The paper adds support to the argument that the cost of higher capital requirements will be mitigated by a reduction in leverage risk which translates into lower borrowing costs and a decline in the required return on equity. In the jargon of the corporate finance wonks, the paper supports a Modigliani Miller (MM) offset.
I need to dig a bit deeper into the results but I am struggling with the finding that increasing the level of subordinated debt at the expense of senior debt results in a reduction in the cost of senior debt. In the interests of full disclosure, I recognise that this may simply reflect the fact that my experience and knowledge base is mostly limited to the Australian and New Zealand banking systems but here goes. As always, it is also possible that I am simply missing something.
The problem for me in these results
We are not debating here the principle that risk (and hence required return) increases as you move through the loss hierarchy. This is a common challenge thrown out at anyone who questions the thesis that risk should decline as you reduce leverage. My concern is that MM did not anticipate a financing structure in which the risk of certain liabilities is mitigated by the existence of an assumption that the public sector will support any bank that is deemed Too Big To Fail (TBTF).
I am not seeking to defend the right of banks to benefit from this implied subsidy. I fully support the efforts being made to eliminate this market distortion. However, so far as I can determine, the reality is that increasing the level of subordinated debt and/or equity may reduce the value of the implied TBTF assumption but senior debt itself does not seem to be any less risky so far as senior debt investors are concerned. So why should they adjust their required return?
This seems to be what we are observing in the response of the debt ratings of the major Australian banks to proposals that they be required to maintain increased levels of subordinated debt to comply with Basel III’s Total Loss Absorbing Capital (TLAC) requirement.
My second concern is not specific to the Bank of England paper but worth mentioning since we are on the topic. One of the MM predictions tested in this study is that “the risk premium on a funding source should fall as that funding source expands at the expense of a more senior one” with the study finding evidence that this is true. This proposition (now supported by another study with empirical data) is often used to argue that it really does not matter how much equity a bank is required to hold because the cost of equity will decline to compensate (the “Big Equity” argument).
What is missing, I think, is any consideration of what is the lower boundary for the return that an equity investor requires to even consider taking the junior position in the financing structure in what is ultimately one of the most cyclically exposed areas of an economy. My last post looked at a study of the returns on both risky and safe assets over a period of 145 years which suggested that risky assets have on average generated a real return of circa 7% p.a.. When you factor in an allowance for inflation you are looking at something in the range of 9%-10% p.a. In addition, there are a range of factors that suggest a bank should be looking to target a Return on Equity of at least 2%-3% over the average “through the cycle” expected return. This includes the way that loan losses are accounted for in the benign part of the cycle and I don’t think that IFRS9 is going to change this.
This is a topic I plan to explore in greater detail in a future post. For the moment, the main point is that there has to be a lower boundary to how much the cost of equity can decline to in response to changes in capital structure but this seems to be largely absent from the Big Equity debate.
I have added a bit of background below for anyone who is not familiar with the detail of how a bank financing structure tends to be more complicated than that of a typical non-financial company.
Tell me what I am missing …
Appendix: A bit of background for those new to this debate
The extent of this MM offset is one of the more contentious issues in finance that has generated a long and heated debate stretching back over more than half a century. Both sides of the debate agree that there is a hierarchy of risk in a company financing structure. Common equity is unambiguously at the high end of this risk hierarchy and hence should expect to earn the highest return. Layers in the hierarchy, and hence the relative protection from solvency risk, are introduced by creating levels of seniority/subordination amongst the various funding sources.
An industrial company could just have debt and equity in which case the MM offset is much easier to analyse (though still contentious). Bank financing structures, in contrast, introduce a variety of issues that render the debate even more complicated and contentious:
- Prudential capital requirements introduce at least three layers of subordination/seniority via the distinction between minimum capital requirements for Common Equity Tier 1, Additional Tier 1 and Tier 2 capital
- The transition to a “bail-in” regime potentially introduces another level of subordination/seniority in the form of an additional requirement for certain (typically large and systemically important) banks to hold Non-Preferred Senior debt (or something functionally equivalent)
- Next comes senior unsecured debt that is one of the workhorses of the bank financing structure (which in turn may be short or long term)
- In certain cases a bank may also issue covered bonds which are secured against a pool of assets (to keep things simple, I will skip over securitisation financing)
- Banks are also distinguished by their capacity to borrow money in the form of bank deposits which also serve as a means of payment in the economy (and hence as a form of money)
- Bank deposits often have the benefit of deposit insurance and/or a preferred super senior claim on the assets of the bank
Apart from the formal protections afforded by the seniority of their claim, certain liabilities (typically the senior unsecured) can also benefit from an implied assumption that the government will likely bail a bank out because it is Too Big To Fail (TBTF). Eliminating this implied subsidy is a key objective of the changes to bank capital requirements being progressively implemented under Basel III.
Until this process is complete, and the implied balance sheet value of being considered TBTF is eliminated, the response of bank funding costs to changes in leverage will not always follow the simple script defined by the MM capital irrelevancy thesis.