Bank capital regulation and the Modigliani-Miller Theorem: a Post-Keynesian perspective

Abstract

This paper challenges the validity for bank regulation of the Modigliani-Miller (MM) Theorems. We argue that the Modigliani–Miller analysis cannot be applied to banks because when lending creates deposits the asset side of banks varies together with the liability side and equity behaves more like a sticky variable. Hence, from an endogenous money point of view and Minsky’s Financial Instability Hypothesis (FIH), much of the debate on bank capital adequacy rules is misleading because: First, it is not at a bank’s discretion to decide the mix of its funding when it provides credit. Secondly, bank liability management might have implications for financial stability as far as it reduces the liquidity in the economy. Bank regulation in the lines of MM Theorems misses both points as long as it disregards the endogenous process of money supply and the effects of financial fragility. In this sense, refutation of the validity of MM Theorems for bank regulation lends support to a Minskian cash-flow oriented bank regulation for the detection of Ponzi finances.

Keywords:

• Bank capital
• Modigliani–Miller
• endogenous money
• financial fragility
• bank regulation

JEL CLASSIFICATION:

• G21
• G32
• B50

Acknowledgements

We would like to thank Marc Lavoie, Christos Pitelis, Stavros Thomadakis, Giorgos Argitis, Anjan Thakor, Robert DeYoung, Michael Kumhof, Spyros Pagratis, Nada Mora (discussant) and seminar participants at Essex Business School, Bank of Greece and ISF2019 for useful comments and suggestions. An older version of this paper has been circulated under the title “Bank Capital and the Modigliani-Miller Theorem When Loans Create Deposits”. We are grateful to the Editor and two anonymous referees for their detailed and constructive comments that have improved considerably the content and exposition of the paper. Any remaining errors are our responsibility alone.

Notes

1 For a constant minimum ratio $MR=\overline{\left(\frac{E}{A}\right)}$ and $\Delta MR=0$ we end up with the expression $\Delta A=\Delta E*\left(\frac{1}{MR}\right).$

2 See https://www.federalreservehistory.org/essays/wwii_to_the_treasury_fed_accord.

3 We would like to thank an anonymous referee for bringing this point to our attention.

4 In principle, the adverse effect on deposits’ convenience yield could be offset by central bank open market operations. The central bank could buy assets from the non-banking sector to counterbalance the reduction of deposits supply and let the convenience yield unaltered.

5 Krishnamurthy and Vissing-Jørgensen (2012) find that Treasury securities carry a convenience yield for safety and liquidity that depends on Treasury supply (i.e., when the supply of Treasury securities decreases the convenience yield rises). They estimate that historically the convenience yield of Treasuries has been around 73 basis points on average.

Additional information

Notes on contributors

George Dotsis

George Dotsis is Associate Professor in Finance, Department of Economics, National and Kapodistrian University of Athens, Research Fellow, Essex Business School, University of Essex.

Konstantinos Loizos

Konstantinos Loizos is Senior Research Fellow, Centre of Planning and Economic Research (KEPE), Athens, Greece, Visiting Lecturer in Banking, Department of Economics, National and Kapodistrian University of Athens, Athens, Greece.