Testing the Modigliani-Miller Theorem of Capital Structure Irrelevance for Banks

Working Paper
15-8
April 2015

Some advocates of far higher capital requirements for banks invoke the Modigliani-Miller theorem as grounds for judging that associated costs would be minimal. The M&M theorem holds that the average cost of capital to the firm does not depend on its capital structure (ratio of equity finance to debt finance), because any reduction in capital cost from switching to higher leverage using lower-cost debt is exactly offset by an induced increase in the unit cost of higher-cost equity capital as a consequence of the associated rise in risk. Statistical tests for large US banks in 2002–13 find that less than half of this M&M offset attains in practice. Higher capital requirements would thus impose increases in lending costs, with associated output costs from lower capital formation. These costs to the economy would need to be compared with benefits from lower risk of banking crises to arrive at optimal levels of capital requirements.

Data disclosure: The data underlying the figures in this analysis are available here [xlsx].

More From

William R. Cline Senior Research Staff

More on This Topic

Working Paper

Kevin Lai (Federal Reserve Bank of New York), Tao Wang (Swarthmore College) and David Xu (PIIE)

December 2019