Do Strict Capital Requirements Raise the Cost of Capital? Banking Regulation and the Low Risk Anomaly

by Malcolm Baker & Jeffrey Wurgler

Overview — 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.

Author Abstract

Minimum capital requirements are a central tool of banking regulation. Setting them balances a number of factors, including any effects on the cost of capital and in turn the rates available to borrowers. Standard theory predicts that, in perfect and efficient capital markets, reducing banks' leverage reduces the risk and cost of equity but leaves the overall weighted average cost of capital unchanged. We test these two predictions using U.S. data. We confirm that the equity of better-capitalized banks has lower systematic risk (beta) and lower idiosyncratic risk. However, over the last 40 years, lower risk banks have higher stock returns on a risk-adjusted or even a raw basis, consistent with a stock market anomaly previously documented in other samples. The size of the low risk anomaly within banks suggests that the cost of capital effects of capital requirements may be considerable. Assuming competitive lending markets, banks' low asset betas implied an average risk premium of only 40 basis points above Treasury yields in our sample period; a calibration suggests that a 10 percentage-point increase in Tier 1 capital to risk-weighted assets may have increased this to between 100 and 130 basis points per year. In summary, the low risk anomaly in the stock market produces a potentially significant cost of capital requirements.