DUKE GHOSH, PH.D.

BANK CAPITAL
STRUCTURE
 CAPITAL STRUCTURE
!
• = 𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜
"
!
• = 𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝑃𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝐷𝑒𝑏𝑡 𝑖𝑛 𝑡ℎ𝑒 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑆𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑒
!"#
#
• = 1 − 𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝑃𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛 𝑡ℎ𝑒 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑆𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑒
!"#

• 𝑁𝑜𝑤, 𝐷 + 𝐸 = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡

! !
• = = 𝐷𝑒𝑏𝑡 𝐴𝑠𝑠𝑒𝑡 𝑅𝑎𝑡𝑖𝑜
(!"#) &

!
• 𝑚𝑒𝑎𝑠𝑢𝑟𝑒𝑠 ℎ𝑜𝑤 𝑚𝑢𝑐ℎ 𝑜𝑓 𝐷𝑒𝑏𝑡 𝑤𝑖𝑙𝑙 𝑏𝑒 𝑔𝑒𝑛𝑒𝑟𝑎𝑡𝑒𝑑 𝑏𝑦 1 𝑈𝑛𝑖𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
"
• This is called Leverage/Gearing

• The balance sheet of a Bank is laden with Debt (Deposits of all kinds)
"
• Hence Prudential Norms stresses on the ratio
#
• How much of equity is brought by the bank to fund its assets
• Banks must not play just with others money!
 CAPITAL REQUIREMENT:
IMPORTANCE
• Capital Structure of a Bank is important for many reasons
• Stability of Banks
• Stability of the Economy as a whole

• Risks are returns are positively related

• There is incentive for Banks to assume inordinately high risks in its investments
• Further, if there is a ”belief” that Government will bail them out in the event of any plausible crisis
• Too high risks may cause bank(s) to fail

• Bank failures are often contagious

• Case in point is the financial crisis of 2007-2008
• Regulators use Capital structure of a Bank to regulate its hunger for assuming risk
• More specifically, Capital Requirement is the means to regulate the Banks
 M&M HYPOTHESIS (FIRST
VERSION)
• First version of M&M Hypothesis (1958) assumes a world with perfectly efficient markets, absence of
asymmetric information, no taxes and no bankruptcy costs
• Proposition 1
• 𝑉$ = 𝑉%
• Irrelevance of Capital Structure Decisions in Value of Firms

• Proposition 2
!
• 𝑟"% = 𝑟"$ + 𝑟"$ − 𝑟!
"
• 𝑟#' = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐿𝑒𝑣𝑒𝑟𝑒𝑑 𝐸𝑞𝑢𝑖𝑡𝑦
• 𝑟#( = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐸𝑞𝑢𝑖𝑡𝑦
• 𝑟! = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡
• A firm’s cost of Equity is directly proportional to its level of leverage
• Higher Leverage implies higher probability of default
• Investors of Equity in a levered firm have to be compensated for assuming higher risk
 M&M HYPOTHESIS (SECOND
VERSION)
• Second version of M&M Hypothesis (1963) assumes a world which closely clones the real world - presence of
asymmetric information, corporate taxes, bankruptcy costs and agency costs
• Proposition 1
• 𝑉' = 𝑉( + 𝑇 ∗ 𝐷
• 𝑇 = 𝐶𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒

• Proposition 2
!
• 𝑟#' = 𝑟#( + [1 − 𝑇] 𝑟#( − 𝑟!
#
• 𝑟!" = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐿𝑒𝑣𝑒𝑟𝑒𝑑 𝐸𝑞𝑢𝑖𝑡𝑦
• 𝑟!# = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐸𝑞𝑢𝑖𝑡𝑦
• 𝑟$ = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡
• A firm’s cost of Equity is directly proportional to its level of leverage
• Presence of Tax Shields make cost of Levered Equity less Sensitive to the Leverage Level
• Investors are reacting to the addition in value through the presence of tax shields
• They react less negatively to the Firms’ taking more debt
 DOES M&M HYPOTHESIS APPLY TO
BANKS?
• Miller (1995) says “Yes and No”
• Banks can operate with higher Equity
• Cost of Equity would decline in response the additional safety provided by a higher over all capital that is caused by
increasing the level of equity
• Dilution of ownership
• Bandwagon Effect
• Further, if the Cost of Equity is too high for a Bank it is because the Equity is too low
• Miller argues that because of the presence of deposit insurance and belief of “too-big-to-fail’, the Banks tend to
operate with lower equity
• Suggests a policy that higher capital requirements are required for regulators to protect the investors (both debt and
equity) interest
• Many have criticized Miller’s arguments
• They point to a set of reasons (“myths” according to those supporting Miller)
 REASON (MYTH) - 1
• Capital (Equity) is the money that must be set aside and, therefore, not available for lending by
banks. Hence an increase in Capital Requirements will reduce lending by Banks

• Response
• It is the Reserve Requirement that is tied up and cannot be lent
• Equity is a source of funds and can be used to invest in loans (assets)
• Equity is a part of the total capital (Equity + Debt) that finances the Assets of the Bank
• Hence, increase in Capital Requirements DOES NOT Pose a constraint to lending by Banks
 REASON (MYTH) - 2
!
• Banks must have a high leverage (𝑎 ℎ𝑖𝑔ℎ 𝑎𝑛𝑑, ℎ𝑒𝑛𝑐𝑒, 𝑎 𝑟𝑒𝑙𝑎𝑡𝑖𝑣𝑒𝑙𝑦 𝑙𝑜𝑤 𝐸𝑞𝑢𝑖𝑡𝑦) because
"
deposits are like factors of production for the Bank (Deposits are like raw materials)

• Response
• Ability to increase deposits is not infinitely large (specially, in presence of competition)
!
• Assume a scenario where the Bank has exhausted raising all cost-effective deposits and has a particular level of
"
• If now, the bank wishes to increase its capital, the only route is the Equity Route
• What if whole or part additional capital raised through equity cannot be invested as loans?
• Bank may invest the surplus in Zero-NPV marketable Securities (Cash Equivalents)
• Raising capital through equity facilitates expansion of the portfolio of Assets
 REASON (MYTH) - 3
• Cost of Deposits are less than that of Equity. Hence, increase of Equity Capital may reduce the value of the
Firm
• Holding the Asset as Constant, if Banks are forced to raise the level of Equity, they will be forced to replace
deposits with Equity
• Response
• True, the cost of deposits is less that that of Equity
• Let us examine the fallacy of this argument through an example
• Banks: A & B
• Asset = 100
• Cost of Unlevered Equity = 10%
• Cost of Deposits (c) = 5%
• There are no taxes
! #
• 𝐹𝑜𝑟 𝐴: = 90% → = 10%
& &
! #
• 𝐹𝑜𝑟 𝐵: = 80% → = 20%
& &
 REASON (MYTH) – 3…CONTD.
• 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑙𝑜𝑎𝑛𝑠(𝑟) = 12% (𝑠𝑎𝑦)
• We shall use this rate to discount the cashflows
• Cashflows are perpetual

• For Bank A:
# ! #
• 𝑟"% = 10% + 10% − 5% ∗ * , 𝑤ℎ𝑒𝑟𝑒, 𝐸& = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝐴 … … … … . (1)
")
• Note, T=0 here (by assumption)
# ((%)*!) ,-%∗,00)1%∗20 3.1
• 𝐸& = * = * = * …………………………….. 2
(+, (+, (+,
• Substituting (2) in (1),
# ! # 20 # #
• 𝑟"% = 10% + 5% ∗ ∗ 𝑟"% = 10% + 5% ∗ ∗ 𝑟"% = 0.1 + 0.6𝑟"%
3.1 3.1
# #
• 𝑂𝑟, 0.4𝑟"% = 0.1 → 𝑟"% = 0.25 … … … … … … … … … … … … … … … . (3)
# 3.1
• 𝑇ℎ𝑒𝑟𝑒𝑓𝑜𝑟𝑒, 𝐸& = = 30 … … … … … … … … … … … … … … … … . . (4)
0.-1
 REASON (MYTH) – 3…CONTD.
• For Bank A, NPV of the investment made by Bank’s Shareholders
• 𝑁𝑃𝑉"# = −𝐵𝑉 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 = −10 + 30 = +20
• For Bank B,
5 ! 5
• 𝑟"% = 10% + 10% − 5% ∗ - , 𝑤ℎ𝑒𝑟𝑒, 𝐸& = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝐵
")
5 ((%)*!) ,-%∗,00)1%∗60 6
• 𝐸& = - = * = *
(+, (+, (+,
5 ! 5 60 5 5
• 𝑟"% = 10% + 5% ∗ ∗ 𝑟"% = 10% + 5% ∗ ∗ 𝑟"% = 0.1 + 0.5𝑟"%
6 6
5 0.,
• 𝑂𝑟, 𝑟"% = = 0.2
0.1
5 6
• 𝑇ℎ𝑒𝑟𝑒𝑓𝑜𝑟𝑒, 𝐸& = = 40
0.-0
• For Bank B, 𝑁𝑃𝑉QR = −20 + 40 = +20
• Thus, in both cases the Market Value of Equity remains unchanged
 REASON (MYTH) – 4
• Increase in Equity Capital means Decreasing ROE
• Hence, shareholders’ value is decreased and shareholders’ interest in banking industry
• This may cause reduction in bank lending – as loans with low interest yield are discontinued

• This argument is flawed

!
• Increase in Equity implies Reduced
"
• The anticipated return by shareholders (expected ROE) also decreases
 THEORIES OF CAPITAL STRUCTURE:
THEORY OF HIGH LEVERAGE
• Banks engage in maturity transformation
• Deposits of lower maturity are pooled together to fund assets with higher maturity (Recall the introductory
discussions)
• To prevent bank-runs, bank needs a discipline within
• Choice of projects they finance
• Timing of cashflows from these projects
• If Equity is a major source (somewhat dominant) source of funds, the discipline in the Banks may be
missing
• Some regulators are of the opinion that this discipline can generated within a bank my making
deposits the major source of funds
• Banks should be highly leveraged
• The act and the associated discipline also makes the economy more liquid
 THEORIES OF CAPITAL STRUCTURE:
THEORY OF HIGH CAPITAL (EQUITY)
• Jensen & Meckling (1976) suggests that there is an asset substitution moral hazard problem in
Banking
!
• A highly leveraged Bank (𝐻𝑖𝑔ℎ ) may attempt to increase the Market Value of their Equity by investing in Riskier
"
Projects
• 𝐻𝑖𝑔ℎ 𝑅𝑖𝑠𝑘 → 𝐻𝑖𝑔ℎ 𝐴𝑛𝑡𝑖𝑐𝑖𝑝𝑎𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛𝑠
• There is a possibility that the high risk associated with projects make the cashflows uncertain and the Expected NPV may
be negative
• High Capital (Equity) minimizes this moral hazard
• Many supporters: Admati & Hellwig (2013), Furlong & Keely (1989), Bhattacharya, et al (1998)

• This argument is enshrined in the Basel Capital Accord (1987)

 THEORIES OF CAPITAL STRUCTURE:
THEORY OF HIGH CAPITAL (EQUITY)
• Does high capital in Bank’s Capital structure help Borrowers?
• Holmstom & Tirole (1997) says Yes!
• How?
• High capital (in capital structure) provides stronger incentives for Banks to monitor their borrowers
• Through FFRs, looking at EWS, etc.
• As a result, Rating Migration takes place (credit worthiness of Borrowers increase)
• They have now access to alternate sources of financing – non-bank sources
• Thus, there is a positive impact on the borrowers as well

• Debt financing provides the Bank with Tax shield

• Interest expenses are tax deductible
 WHAT DOES EMPIRICAL
EVIDENCE POSIT?
• Higher capital requirements have allowed banks to grow faster [Calomiris & Powel, 2001; Calomiris
& Mason, 2003; Calomiris & Wilson, 2004]
• Both in terms of deposits and loans
• Allows the bank to have higher market share during financial crises

• Bank value and Equity Capital are positively correlated in the cross section (Mehran & Thakor, 2011)
• Value calculated during Bank’s Acquisition are positively correlated with Bank’s Capital (Mehran &
Thakor, 2011)
 WHY BANKS PREFER HIGH
LEVERAGE?
• To avail Tax Shield
• Interest on Debt is Tax-Deductible at the Firm Level
• Minimization of Tax burden is a major consideration
• Debt Overhang and Problem of Under Investment
• Payment to debt holders is obligatory
• Payment to Equity Holders is residual (and junior)
• If the existing Debt level is high, the Bank may have to refrain from investing in lucrative positive NPV projects as
the benefits of these projects will not accrue to the equity holders (the debtholders will enjoy the benefits)
• ROE & Executive Compensation
• Executive’s compensation is based on ROE of a Bank
• Executives discourage capitalizing in the fear that ROE will go down
• Deposits Insurance
• As long as deposit insurance is in force the premium is divorced from the risk that the Assets of the Bank face,
there is incentive to increase leverage
 BANK EQUITY AND BANK CAPITAL
• Bank Capital = Core Capital + Tier 1 Capital + Tier 2 Capital + Tier 3 Capital
• Core Capital (also called Core Tier 1 Capital) = Book Value of of the Paid-up Capital
• Support Losses on an on-going basis without triggering liquidation
• Unconditionally risk absorbing and permanently available

• Tier 1 Capital = Core Capital + Certain Preferred Stocks

• Tier 2 Capital = Core Capital + Tier 1 Capital + Certain Hybrid Instruments (quasi-debt/quasi-equity) of
sufficiently long maturity + Subordinated Debt Instruments
• Fixed maturity and and inability to absorb losses except in liquidation
• Tier 3 Capital = Core Capital + Tier 1 Capital + Tier 2 Capital + Subordinated Short Term Debt
• Absorb banks risks to Foreign Exchange Exposure
• Absorbs risk associated with Commodities Risk
• Post 2007-2009, Banks Capital Requirements have been tightened
• Stress on Risk Weighted Assets
THANK YOU