Alan Greenspan's paper on the financial crisis calls for regulatory capital requirements on banks to be increased but also warns that there are limits to how much they can be increased. In his words: "Without adequate leverage, markets do not provide a rate of return on financial assets high enough to attract capital to that activity. Yet at too great a degree of leverage, bank solvency is at risk." Greg Mankiw wonders whether the above assertion does not violate the Modigliani-Miller Theorem and is right to do so. Although Greenspan's conclusion is correct, his argument is incomplete and misses out on the key reason why leverage matters for banks - the implicit and explicit creditor guarantee.

I explained the impact of creditor protection on banks' optimal leverage in my first note. The conclusions which I summarised in a more concise form in this note are as follows: Even a small probability of a partial bailout will reduce the rate of return demanded by bank creditors and this reduction constitutes an increase in firm value. In a simple Modigliani-Miller world, the optimal leverage for a bank is therefore infinite. Even without invoking Modigliani-Miller, the argument for this is intuitive. If each incremental unit of debt is issued at less than its true economic cost due to deposit insurance or the TBTF doctrine, it "increases the size of the pie" and adds to firm value. In reality of course, there are many limits to leverage, the most important being regulatory capital requirements.

Indeed, the above is the main reason why we have any regulatory capital requirements at all. In the absence of regulation, a bank with blanket creditor protection will likely choose to operate with minimal equity capital especially when it has negligible franchise value or is insolvent. This is exactly what happened during the S&L crisis when bankrupt S&Ls with negligible franchise value bet the farm on the back of a capital structure almost completely funded by insured deposits.


Bill Miller

this is why the seizure of fannie mae and freddie mac and the wiping out of shareholder's equity including preferred equity that counted as tier 1 capital in the banking system was economically idiotic, though politically much applauded: those entities operated with a govt guarantee of their debt, so could never become insolvent in the sense of being unable to meet liabilities as they come due. they don't need accounting equity, which makes it silly for the govt to inject "equity" into them as losses eat thru the accounting equity line item. and of course the govt is not putting equity in at all--it is just issuing more debt and calling it equity. but the seizure of the gse's did wipe out real equity of common and preferred shareholders, whom the govt had encouraged to invest in those entities earlier in the year. the completely gratuitous preferred dividend elimination also eliminated capital from the banking system at the same time as treasury was telling banks to raise more capital. no wonder it only took 7 days from that for lehman to fail, merrill to be sold, aig to collapse etc. premptive seizure led to preemptive action to get one's cash out of financial institutions that might be the next to be seized.


Bill - I agree. Forcing a writedown of the equity when the debt is guaranteed may look good in the press but is economically meaningless.

Bank Capital and the Monetary Transmission Channel: The Importance of New Firm Entry at Macroeconomic Resilience

[...] injection of capital. Again, this is not far from the truth: As I have explained many times on this blog, banks are motivated to minimise capital and given the “liquidity” support extended to [...]