The value of Modigliani-Miller – like any good model in physics or economics – lies as much in the questions it raises as in the truths it reveals.
The Financial Times is the only world newspaper whose letters page could feature extended correspondence on the theory and evidence supporting the Modigliani-Miller theorem. But the issues are important even to readers of the Daily Mail.
Equity capital costs more than debt because it is riskier. But if a business – a bank, for example – increases its equity relative to its debt, that reduces the riskiness of the equity because operational risks are spread over a wider base. Reduced leverage also reduces the riskiness of the debt – there is a larger cushion of equity to protect the creditors. These propositions should be uncontroversial.
But if equity and debt are both less risky, their price should be lower. So although higher bank capital requirements increase the ratio of expensive equity to cheaper debt, the higher average cost should be mitigated by lower rates on both equity and debt. The ingenuity of Professors Franco Modigliani and Merton Miller was to show that under certain conditions these factors would be perfectly offset.
In their model, the cost of capital to a business is therefore unaffected by the ratio of equity to debt. The riskiness of a business rests on the volatility of its earnings from operations, and financial engineering can influence only the manner in which risks are shared among different investors.
As some letter writers pointed out, this theory may not be borne out in practice. And as David Miles, the Bank of England monetary policy committee member who first raised the issue on this page, recognised – if the theory is not borne out, it is reasonable to ask why. Perhaps the Basel agreements will not in practice make bank debt or equity less risky. Or perhaps, the banking system will be less risky but the capital market will not believe so. A third explanation is that competition in banking is so weak that there is little relationship between the rates of return banks earn and the cost of their capital.
There is probably some truth in each of these. One letter writer noted that a Bank of England study showed little relationship between banks’ capital ratios and funding costs. The implication is that even if the Basel committees think capital adequacy a good measure of a bank’s soundness, the market does not.
Last month Vikram Pandit, chief executive of Citigroup, explained on this page why the market may have got it right: “Improper calibration also fails to level both the institutional and geographical playing fields. Different kinds of institution are regulated differently (and some not at all) while different countries are allowed to implement as much, or as little, of Basel as they like.”
His only mistake was to imply that something useful can be done about “improper calibration”. The notion that a committee can finely calibrate the risk associated with a variety of asset classes, many instruments, and a wide range of institutions on a basis which is at once objective and economically meaningful, is an illusion.
The Bank for International Settlements has estimated the costs of the new Basel obligations. Its estimates assume banks target – the BIS’s word – a rate of return on equity of 15 per cent. This is revealing. In most industries, companies may aim for high rates of return but competitive markets ensure they end up with much less. Only the most ambitious hedge funds target rates of return above 15 per cent in raising risk capital for financial markets. Utilities engaged in provision of infrastructure services are regulated to earn considerably less. Why should a conglomerate bank earn more? If banks do indeed earn 15 per cent on a much expanded capital base, then they will impose a tax on the non-financial economy, which is an obstacle to growth and innovation.
The value of Modigliani-Miller – like any good model in physics or economics – lies as much in the questions it raises as in the truths it reveals. Responding to these questions suggests that higher bank capital ratios will impose significant costs on the non-financial economy without contributing much to financial stability.