Does Opaqueness Make Equity Capital Expensive for Banks?
Faz opacidade caro capital patrimonial para os bancos?
Banking differs from other industries in many ways. One of the most obvious differences is the funding structure. If one looks at the annual reports of companies in manufacturing or non-financial services, corporate debt almost never accounts for 90 - 97% of the balance sheet total. Such an extreme leverage is the norm rather than an exception among banks, and because of various off-balance sheet operations the true leverage is often even more extreme. If the government did not impose capital adequacy regulations on banks, capitalisation might be even weaker. Why is banking so different from other industries? Bank managers consider equity "expensive", but why does equity become more "expensive" in relative terms if it is used to finance loans instead of, say, machinery? This paper intends to present a potential explanation to this phenomenon.
The tendency to perceive equity "costly" seems to contradict the irrelevance theorem of Modigliani and Miller (1958). This theorem is based on a number of assumptions. For instance, it is assumed that the value of assets is not affected by the structure of the liability side of the balance sheet. This assumption is not necessarily valid in banking. Diamond (1984) proposes that debt on the balance sheet induces the banker to monitor debtors because no loan losses can be passed on to financiers. Diamond and Rajan (2001) propose that weak solvency may be a strategic commitment against debtors' attempts to renegotiate loan contracts. Calomiris and Kahn (1991) propose that depositors' possibility to make withdrawals might induce the banker not to abscond with the funds. Debt issued by banks has got both preferential fiscal treatment and implicit and explicit government guarantees, encouraging extreme leverage (Keeley 1990, Admati et al., 2010). The relative costs of debt and equity capital may not differ from other industries, but the cost of funding is more essential in financial intermediation than in, say, retail trade (see Hanson et al., 2011). Different explanations to bank aversion to strong capitalisation are not mutually exclusive.
Interestingly, this tendency to regard capital "expensive" has become stronger over time. In the past, banks used to have much more equity capital in relative terms, and obviously bank managers did not find equity particularly expensive. (See e.g. Ahman 1943 p. 70, Saunders & Wilson 1999; Thies & Gerlowski 1993) This change in the way of thinking may be due to implicit and explicit governmental safety nets, or, as will be proposed in the following, to the increasing opaqueness of modern banking.
This paper combines previous theories on bank runs and dividend signalling. The original Diamond-Dybvig (1983) model was intended to explain why and how banks convert short-maturity deposits to long-term investments, and what kinds of risks are involved. The idea of using dividends to signal profitability was briefly discussed already by Miller and Modigliani (1961, p. 430), and a seminal theoretical contribution was presented by Bhattacharya (1979); paying dividends is wasteful because of tax reasons, but if paying them is less expensive for profitable firms than for less profitable ones, dividends are a credible signal, and they enhance the market value of the firm. Recent empirical evidence in favour of this approach is presented by e.g. Al-Yahyaee et al., (2011). Dividend cuts may be an especially adverse signal, and empirical evidence reviewed in section five indicates that avoiding them drives many companies' dividend policies.
Dividend cuts may have adverse signalling effects in any industry, but the effect is probably particularly strong in banking. There are two reasons for this.
1) Banks are inherently opaque. Rating agencies disagree on banks' creditworthiness more often than in the case of comparable companies in other industries (Iannotta, 2006; Morgan, 2002), and these disagreements have become more commonplace over time (Morgan, 2002). Further evidence on bank opaqueness is presented by e.g. Hirtle (2006). The absence of other sources of information increases the relative role of any available signal.
2) In no other industry the value of a company depends as strongly on how counterparties perceive it. Deposit runs can be triggered even by self-fulfilling expectations, let alone adverse signals. Deposit runs do not occur in mining and manufacturing.
When bank opaqueness is discussed, the focus is often on the asset side of the balance sheet, but even broadly understood bank liabilities have become opaque. For instance, many banks have established off-balance sheet investment vehicles, such as SIVs and conduits, that acquire loan funding in the market, but are effectively guaranteed by the sponsoring bank without being included in the publicly disclosed group balance sheet. If a bank arranges a commercial paper program and sells credit risk protection against defaults on this debt in the CDS market, it is effectively collecting short-maturity funding in order to finance its customer, and the bank does not dispose of the default risk. However, no additional debt is reported on the balance sheet.
These days even supervisors with their privileged access to confidential information often seem unable to assess the true leverage of banks. At least it is difficult to mention any pre-crisis initiatives of supervisors to regulate off-balance sheet vehicles. Increasing opaqueness must have some impact on the signalling value of whatever the bank does in the market.
Even though banks have no legal obligation to pay dividends, equity capital appears paradoxically about twice as expensive as debt in terms of cash flows.
The OECD (2010, p. 11) published the list of the ten largest banks in the euro area in 2006. In the light of data found in annual reports, the non-weighted average ratio of dividends to the book value of shareholders' equity in this group was 8,7% in 2006, the last year before the financial crisis, and the median was 7,0%. The annual average interest rate on non-collateralised three months interbank loans, the Euribor rate, was 3,1% in 2006. In no bank of the sample the dividend yield on shareholders' equity was lower than this average money market rate. Hence, prior to the global financial crisis, the market was used to bank dividends higher than the rate of interest banks on bank debt, and paying something less would have been an adverse signal.
The model presented in this paper combines dividend signalling models and the Diamond-Dybvig bank run model. The bank needs to hold extra liquidity instead of illiquid yet return generating assets in order to be able to make large dividend payments; not doing so might trigger a deposit run. The dividend has got value as a Spencian signal because profitable institutions can finance larger payments than unprofitable ones. If the bank is opaque, it is not possible to say what the true leverage of the institution is, and observers pay attention to the easily observable dividend per share, not to the non-verifiable ratio of total dividends to risks or assets. The more equity has been issued, the more dividend payments the bank must be prepared to pay in total, which is costly.
Section two presents the assumptions of the model. Sections three and four analyse two different versions of the model. Section five compares the findings of the theoretical analysis and some previous empirical observations. Section six discusses the findings.
There is a bank. The bank is a monopoly. It can acquire funding from investors with two financial instruments.
1) Short-term deposits with a fixed interest rate.
2) Permanent equity capital.
There is a given number (N, N >> 0) of uncoordinated investors. The bank knows how numerous they are and where to find them. Each investor has got one unit of monetary savings to be invested in either bank equity or deposits. Each investor can also keep the sum as risk-free currency.
There are two kinds of investors. Type A investors know they will need no means of payment before the planned closure of the bank at stage five (see below). They accept both equity investments (E) and deposit contracts (D). Type B investors run the risk of being subject to a liquidity shock at stage four, and they do not accept equity because not consuming at an early stage would result in huge disutility. The number of type B investors who may be subject to a liquidity shock is N[OMEGA], and the probability of a shock is [lambda] (0
It would be unrealistic to assume that the bank would know the probability of a liquidity shock better than the savers themselves; therefore [lambda] is publicly known. Instead, information on bank financiers is not observable without insider information. Therefore, it is meaningful to assume that omega is not publicly known but lambda is.
Things happen in the following order.
1) Funding; The bank observes what kinds of investment assets are available. It observes the realisation of the liquidation value (Z, 0
2) Investments; The bank decides how much to invest in an illiquid yet productive asset and how much to keep as liquidity buffers (L) consisting of risk-free currency with no return. The sum of investments (I) and liquidity must equal the sum of equity and deposits (I + L = E + D). The bank cannot prove to anyone the amount of investments it has made.
3) Returns realised; The bank privately learns the return on its investments but cannot credibly prove this information to anyone. In most cases, with probability [theta], the return on investments is normal, and the bank receives in cash the sum of the return [alpha] (0
4) Withdrawing; Each depositor is paid the interest rate [delta] (0
5) End; Investments mature. Each unit of investments not liquidated at stage four is now worth the original investment 1. If...