Since the 2008 financial crisis, many have proposed that banks be required to hold more capital to improve the safety of the financial system. The author discusses a new paper that argues that leverage is necessary to meet the public’s demand for money-like assets. Thus, forcing banks to hold more capital may not always be wise.
In the five years since Lehman Brothers failed, many have suggested that banks should fund themselves more with equity and less with debt to make the financial system safer. The author discusses a new paper by DeAngelo and Stulz (working paper 2012) that recommends banks be highly levered even without such frictions as deposit insurance and implicit guarantees.
How Is This Article Useful to Practitioners?
A safe financial system is essential for the smooth functioning of capital markets. As Modigliani and Miller (American Economic Review 1958) noted, the value of an enterprise does not depend on its mix of debt and equity, all other things being equal. If a bank issues more equity, it will be less likely to go bankrupt. As a result, its equity should be safer and, therefore, cheaper.
Less bank leverage, however, is not always good either. Banks charge a liquidity premium as a price of convenience for bank deposits because they are highly liquid, a store of value, and convenient for settling transactions; they also require no due diligence. DeAngelo and Stulz suggest that as the liquidity premium shrinks, banks must crank up their leverage to compensate.
The push for lower leverage and more equity could constrain banks’ capacity to supply people with money-like assets, pushing them into “quasi-safe” shadow-banking debt—commercial paper, “repo” loans, and money market funds—which may lead to a more fragile financial system. The author rightly concludes that US and European regulators’ efforts to regulate money market funds may also push investors in search of a money-like asset into another shadowy corner of the system.