Bank leverage and credit supply.

• Author: Shin, Hyun Song
• Position: Research Summaries

Banks and other types of financial intermediaries are of special interest given their role in the economy and as their balance sheet decisions have direct implications for credit supply. In spite of this, financial firms are routinely excluded from the data samples in empirical studies in corporate finance. This means that some of the features of financial firms that make them special are often not addressed. Peering into the corporate finance of banks reveals some important lessons.

Basics of the Corporate Finance of Banking

Consider something as basic as leverage. Define leverage as the ratio of total assets to the equity of a firm. Figure 1, at the upper right, shows three ways that a firm (financial or otherwise) can increase its leverage. In each case, the gray shaded area represents the balance sheet component that does not change.

Mode 1 on the left is the case typically dealt with in MBA textbooks in corporate finance. It depicts a financial operation where the firm issues debt and buys back equity with the proceeds of the debt issue. The assets of the firm are unchanged. This is the way, for instance, that a private equity fund would acquire a target firm. Mode 2 depicts the consequences of a dividend paid to shareholders financed by an asset sale. The leverage goes up because the debt remains in place, but the assets shrink in value. The shrinking of the asset value could reflect simply a decline in the price of the assets, so that the increase in leverage is the result of market value changes.

However, for banks neither Mode 1 nor Mode 2 turns out to be the right picture. Banks adjust their leverage as in Mode 3, where new assets are financed by issuing new debt, with equity varying very little.

Figure 2 shows the scatter plot of the change in total assets, debt, and equity of Barclays. Each point corresponds to a change in one of these measures over a two-year period during the 18-year period of 1992 to 2010. There are nine such intervals. The data show very small changes in equity, even when assets change substantially during a two-year period. However, for debt the fitted line through the scatter plot between the change in assets and the change in debt has a slope very close to one, meaning that the change in assets is almost all accounted for by the change in debt, just as in Mode 3 above. Since the total assets of the bank and the leverage of the bank move in lockstep in Mode 3, a theory of bank leverage gives a theory of bank credit supply.

Book Value of Assets and Bank Lending

The equity series in the scatter chart shows changes in the book value of equity, not the market capitalization of the bank. In empirical corporate finance studies for non-financial firms, it is customary to give more...