A recent post looked at a Bank of England paper that offered evidence 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 equity. My post set out some reasons why I struggled with this finding.
My argument was that,
- in banking systems where the senior debt rating of banks assumed to be Too Big To Fail is supported by an implied assumption of government support (such as Australia),
- increasing the level of subordinated debt could reduce the value of that implied support,
- however, senior debt itself does not seem to be any less risky (the senior debt rating does not improve), and
- the subordinated debt should in theory be more risky if it reduces the value of the assumption of government support.
Fortunately, I also qualified my observations with the caveat that it was possible that I was missing something. Recent issuance of Tier 2 debt by some Australian banks offers some more empirical evidence that does seem to suggest that the cost of senior debt can decline in response to the issuance of more junior securities and that the cost of subordinated debt does not seem to be responding in the way that the theory suggests.
My original argument was I think partly correct. The prospect of the large Australian banks substantially increasing the relative share of Tier 2 debt in their liability structure has not resulted in any improvement in the AA- senior debt rating of the banks subject to this Total Loss Absorbing Capital requirement. So senior debt does not seem to be any less risky.
What I missed was the impact of the supply demand dynamic in a low interest rate environment where safe assets are in very short supply.
The senior debt in my thesis is no less risky but the debt market appears to be factoring in the fact that the pool of AA- senior debt is likely to shrink relative to what was previously expected. Investors who have been struggling for some time to find relatively safe assets with a decent yield weigh up the options. A decent yield on safe assets like they used to get in the old days would obviously be preferable but that is not on offer so they pay up to get a share of what is on offer.
The subordinated debt issued by these banks might be more risky in theory to the extent that bail-in is now more credible but if you do the analysis and conclude that the bank is well managed and low risk then you discount the risk of being bailed-in and take the yield. Again the ultra low yield on very safe assets and the shortage of better options means that you probably bid strongly to get a share of the yield on offer.
Summing up. The impacts on borrowing costs described here may look the same as what would be expected if the Modigliani-Miller effect was in play but the underlying driver appears to be something else.
It remains possible that I am still missing something but hopefully this post moves me a bit closer to a correct understanding of how capital structure impacts bank funding costs …