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Making A Difference

A new view of the cost of equity and capital requirements for banks

Malcolm Baker

Capital requirements for banks, which govern the ratio of equity to debt, have come under greater scrutiny in the wake of the 2008 financial crisis. A central question is how these requirements affect banks’ overall cost of capital, or the minimum return that investors expect, which influences lending rates and economic activity. Prevailing economic theory holds that the cost-of-capital effect is negligible in an ideal market.

Malcolm P. Baker, the Robert G. Kirby Professor of Business Administration, has investigated this issue and discovered what he calls the low-risk anomaly: while the positive relationship between risk and return is strong between asset classes (say, stocks and bonds), it is weak within classes, such as the stock market. By analyzing a large sample of historical data from US banks, Baker has found that the low-risk anomaly may represent a previously unrecognized and possibly substantial downside of heightened capital requirements.

“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 documents in non-financial firms and in other development markets,” says Baker. “Together with the pattern that more conservative capital structures reduce the risk of equity, this finding suggests a cost of heightened capital requirements in the form of costlier equity.”

(Published May 2015)