- 06 Jun 2013
- Working Paper Summaries
Do Strict Capital Requirements Raise the Cost of Capital? Banking Regulation and the Low Risk Anomaly
The instability of banks in the financial crisis of 2008 has stoked the enduring debate about optimal capital requirements. One of the central concerns has long been the possibility that capital requirements affect banks' overall cost of capital, and therefore lending rates and economic activity. In this paper, the authors estimate how leverage affects the risk and cost of bank equity and the overall cost of capital in practice. They are especially motivated by the potential interaction of capital requirements and the "low risk anomaly" within the stock market: That is, while stocks have on average earned higher returns than less risky asset classes like corporate bonds, which in turn have earned more than Treasury bonds, it is less appreciated that the basic risk-return relationship within the stock market has historically been flat-if not inverted. Using a large sample of historical US data, the authors find that the low risk anomaly within banks may represent an unrecognized and possibly substantial downside of heightened capital requirements. However, despite the fact that tightened capital requirements may considerably increase the cost of capital and lending rates, with adverse implications for investment and growth, such requirements may well remain desirable when all other private and social benefits and costs are tallied up. Key concepts include: Many economists make the theoretical argument, built on efficient markets, that heightened capital requirements will have a modest effect on the overall cost of capital, because more capital lowers the risk of equity and hence its cost. Capital requirements are likely to lower the risk of equity, but not its cost. The "low risk anomaly," which says that the link between risk and return is weak or inverted and appears in both U.S. and international equity markets, is also apparent within banking stocks. Lower risk banks have the same or higher returns than higher risk banks. Unless long-term and worldwide patterns are reversed, reducing equity beta will not reduce the cost of equity. When all other private and social costs and benefits are totaled up, strict capital requirements may well remain desirable. However, the low volatility anomaly produces an underappreciated and potentially significant cost to consider. Closed for comment; 0 Comment(s) posted.
- 17 Aug 2012
- Working Paper Summaries
While managers appear to view dividends as a signal to investors, managers also argue that standard dividend signaling models are not focused on the correct mechanisms. These standard models posit that executives use dividends to destroy some firm value and thereby signal that plenty remains: The "money burning" typically takes the form of tax-inefficient distributions, foregone profitable investment, or costly external finance. Executives who actually set dividend policy overwhelmingly reject these ideas yet, at the same time, are equally adamant that dividends are a signal to shareholders and that cutting them has negative consequences. In this paper, the authors develop what they believe to be a more realistic signaling approach. Using core features of prospect theory as conceptualized by Daniel Kahneman and Amos Tversky (the fathers of behavioral economics), they create a model in which past dividends are reference points against which future dividends are judged. The theory is consistent with several important aspects of the data. Baker and Wurgler also find support for its broader intuition that dividends are paid in ways that make them memorable and thus serve as stronger reference points and signals. Key concepts include: The essence of Baker and Wurgler's stylized model is that investors evaluate current dividends against a psychological reference point established by past dividends. This model is consistent with several facts about dividend policy that cannot be handled in static models. This paper focuses on two central features of the prospect theory value function: that utility depends on changes in states relative to a reference point, and that losses bring more pain than symmetric gains bring pleasure. Closed for comment; 0 Comment(s) posted.
- 06 Jun 2007
- Research & Ideas
Do investors really behave rationally? Behavioral finance researchers Malcolm Baker and Joshua Coval don't think humans are such cold calculators. One proof: Individual and even institutional investors often give in to inertia and hold on to shares in unwanted stock. And therein lays opportunity for investment managers and firms. Key concepts include: Far from acting in their own best interest, many individual and institutional investors are more inertial than logical when it comes to emptying their portfolios of unwanted shares. Behavioral finance replaces the traditional and idealized idea of rational decision makers with real and imperfect people who have social, cognitive, and emotional biases. The resulting inefficiencies in the capital markets can create opportunities for investment managers and firms. Closed for comment; 0 Comment(s) posted.