Monetary Policies and Banking Fragility - Case Study Example

Student Name Tutor Title: Monetary Policies and Banking Fragility Institution Date Monetary Policies and Banking Fragility Introduction Setting capital requirements or share capital is a major policy issue for regulators and ultimately governments in the world over. The recent past is one characterized by a major banking crisis, a financial crisis of 2007-2008 accompanied by dramatic decline in economic activity and a huge widening in fiscal deficits in various nations however, for the UK, this was probably the most serious banking crisis in its history. In its wake, output fell on a scale that was, on some measures, as serious as during the first stage of what we now call the Great Depression. It is likely to be the longest of the six depressions since the First World War (Miles, 2011). Following the financial crisis, the cost to the economy of the financial crisis and the scale of public support to the financial sector has been enormous. Mixed opinions underlie most discussions on capital regulations and various monetary policies as well as banking fragility by making maximum use of share capital. With the positivists associating the move with substantial benefits in preventing crises whereas the pessimists link it to imposing of costs on the financial system as well as on the economy. This paper is based on the Speech made by David Miles, who aimed at assessing whether an increase in the banking sectors level of equity capital would reduce GDP and make the bank of England task of setting monetary policy more difficult. The question raised is whether Banks move to increase share capital will or will not reduce the level of loan and therefore GDP and whether it is true that increasing capital will increase cost of bank funds. This paper therefore intends to find answers to the raised questions while reviewing various arguments around the main topic, monetary policies and banking fragility. The paper will start by defining key terms followed by the main body which will include discussions on the raised questions and finally a conclusion based on analysis and discussions of the foregoing paragraphs. Definition of key terms Share Capital Share capital or equity financing simply entails capital raised by the company by issuing shares to general public usually in return for cash or other considerations. A particular amount of share capital a company has can change over time because each time a business sells new shares to the public in exchange for cash, the amount of share capital will increase. Share capital are composed of Authorized / Registered/ Nominal capital, issued capital, Subscribed capital, Called up capital and paid up capital. Gross Domestic Product (GDP) GDP can be simply defined as the total market value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of imports. Banks to keep move share capital will it reduce the level of loan and therefore GDP? There are mixed arguments concerning the question, whether there will be a reduced level of loan and therefore GDP if Banks move or increase share capital. To a great extent this may not be true for various reasons. For one, increase in share capital or higher equity capital requirements do not automatically limit banks’ activities for instance lending or loans borrowing , deposits taking and the issuance of liquid money-like, particularly and informational, insensitive securities. Secondly, it is also believed that banks can maintain all their existing assets and liabilities and reduce leverage through equity issuance and the expansion of their balance sheets. In a way that equity issuance improves the position of existing creditors and it may also be interpreted as a negative signal on the bank’s status. Instead, banks might privately prefer to pass up borrowing or lending opportunities if at all they must or have to fund them with share capital. Furthermore, in case of any outstanding amounts, the bank can be able to alleviate it if regulators require undercapitalized banks to recapitalize quickly by restricting equity payouts and mandating new equity issuance. Once better capitalized, banks would make better their lending and investment decisions and therefore issuance costs would be reduced. More evidence to prove that increase in share capital may not correspond to reduced lending can also be illustrated by considering the history of both UK and in the USA economic performance which was not only observably far worse but also the spreads between reference rates of interest and the rates charged on bank loans were not obviously higher, when banks had to increase their respective share capital. This could clearly mean that at all, an increase in share capital do not translate to a crippled development, or seriously hinder the financing of investment that is reducing borrowing consequently reduced GDP. Again, looking back at the past histories of the aforementioned economies, there is very scanty evidence that investment or the average (or potential) growth rate of the economy picked up as leverage moved sharply higher in recent decades as illustrated in the next paragraphs. While reviewing a long run series for UK bank leverage (total assets relative to equity) and GDP growth it is evidently that there is no clear link. Arguably, between 1880 and 1960 bank leverage was, on average, only approximately half the level of recent decades. According to Miles, Yang and Marcheggiano (2010) the bank leverage shown an upwards trend for 100 years; the average growth of the economy has shown no obvious trend. Moreover, it is also not clear that spreads on bank lending were significantly higher when banks had higher share capital. In fact, Bank of England data indicates that spreads over reference rates on the stock of lending to households and companies since 2000 have averaged close to two percent. Evidence indicates that the spread over Bank Rate of much bank lending at various times in the twentieth century was consistently below two percent. Additionally, a review of the US economy shows a significant increase in leverage of the banking sector over the twentieth century was not accompanied by a reduced bank borrowing or lending, however the two series, UK and US are mildly positively correlated so that as banks used less equity to finance lending the spread between the rate charged on bank loans to companies and a reference rate actually increased. (Miles, Yang and Marcheggiano, 2010).Nonetheless, the evidence presented is not substantial to conclusively support any claims that increasing share capital corresponds to cost of borrowing for firms and consequently reduced GDP. Another reason for opposing the bank’s view that an increase in share capital would lead to reduced lending and GDP is based on the theory or model of the overall impact of the increase in share capital or equity but less debt upon the total cost of financing of a company implying that the effect is zero. Accordingly, The Modigliani-Miller (MM) theorem, as more equity capital is used the volatility of the return on that equity falls, and the safety of the debt rises, so that the required rate of return on both sources of funds falls and does so in such a way that the weighted average cost of finance is unchanged or not affected (Modigliani and Miller 1958). From the a foregoing illustrations it imperative that it is self-evident that requiring banks to use more equity and less debt has to be accompanied by an increase in their funding cost and therefore need to charge substantially more on loans to service the providers of their funds. Kashyap and his colleques observed that the long-run steady-state impact on bank loan rates from increases in external equity finance is modest, particularly in the range of 25-45 basis points for a ten percentage point increase in the ratio of capital to bank assets, which would roughly halve leverage (Kashyap et al., 2010). Banks argue that increasing capital will increase cost of bank funds Despite the fact that equity, because it is riskier, has a higher required return than debt, the use of more equity funding does not interfere with the overall funding cost of banks. Using more equity financing lowers the riskiness of a bank’s equity and perhaps also of its debt. Unless those who fund the bank are fooled so that securities are mispriced, simply shifting the way that risk is borne by different investors need not have any direct effects on the overall funding cost of the (Miles, Yang and Marcheggiano, 2010). Kashyap, Stein, and Hansen (2010) while using data on US banks, observed a positive relationship between a bank’s equity risk and its leverage. They concluded that an increase in equity financing will not affect the cost of bank funding significantly, aside from tax factors. However, various distortions and frictions in the economy do affect banks’ cost of debt and equity finance. Some of the most important frictions and distortions are actually created by public policy. For example, most tax systems give an advantage to debt financing and penalize equity financing. Some of the arguments against higher equity capital requirements are based on the “costs” banks would incur if they had to give up some of this subsidized debt financing. Therefore it follows that from a public policy perspective these arguments are wrong since they inappropriately focus on private costs to the bank rather than social costs. Ideally, taxes should be structured to minimize the overall distortions they induce, which mean that they should encourage behavior that generates positive externalities and discourage behavior that generates negative externalities. A tax system that encourages banks to take on socially costly excessive leverage is highly distortionary and dysfunctional. If the banking system needs to be subsidized, more effective and less costly ways must be found to do that. Taking the tax code as given is inappropriate in this context; all relevant aspects of public policy should be considered. Again, from the standpoint of Modigliani–Miller theorem which is also called capital structure irrelevance principle, this may not be true that is, increasing share capital would not reduce lending and consequently GDP. According to the principle, that any under a certain market price process, but in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information while in an efficient market, the value of a firm is not affected by how that firm is financed (Marco Pagano, 2005). Thus contrary to the Bank’s argument, it really does not really matter whether the company’s share capital is raised for instance by giving stock or selling debt or the firms’ dividends due to the following reasons: One, that firm’s share capital (market value of its shares and debts) equal the present discounted value of the firm’s cash flow, gross of interest, where the discount rate is the required return for firms of the same “risk class”. To this end, it is therefore imperative that the firm’s value is basically influenced solely by this discount rate and its cash flows including the firm’s assets, and it is in every respect independent from the composition of the liabilities used to finance those assets. Secondly, from the virtue of the fact that the typical or average cost of capital is self-determining and not influenced by the volume and structure of debt and it equals the return required by investors for firms of the same “risk class”. Sometimes this debt may emerge to be cheaper compared to the equity, owing to the absence of a risk premium. Thus increasing leverage does not reduce the average cost of capital to the firm, because its effect would be precisely offset by the greater cost of equity capital. Marco Pagano (2005) has argued that firms can always deduct interest payments, instead of dividends, as a cost to set against their corporation tax payments (though this effect can be offset, possibly completely, if at all returns to shareholders in the form of dividends and capital gains are taxed less heavily at the personal level than are interest receipts. In the same vein, evidence also indicates that tax distortions have a significant influence on financial structure (Auerbach, 2002; Graham, 2003; Cheng and Green 2008; Weichenrieder and Klautke, 2008) Elsewhere, Desai et al (2004) have estimated the impact on the debt-asset ratio to be 2.6 percentage points and therefore explaining why increase in share capital cannot have any effect on lending. Furthermore, in situations of stricter capital requirements , banks tends to be less able to exploit any favourable tax treatment of debt however, the extra corporation tax payments are neither lost to the economy nor the value of any extra tax revenue to the government offsets any extra costs to banks. In fact, the extra tax could be instead assist to defuse or neutralize the impact on the wider economy of any increase in banks’ funding costs. Miles, Yang and Marcheggiano, (2011) have argued that a debt/equity swap may be still completely neutral so that when bank debt is mainly held by a small number of institutional investors, bank bonds and equity tend to have somehow a similar ability to discipline bank management. According to the three scholars, if bank bonds and equity have similar characteristics the swapping of some bonds for equity would not have any a big impact thus it would not reduce the amount of funds that the bank can attract. Increasing the capital ratio does not have to reduce bank lending since a gradual reduction in leverage does not impose substantial costs on banks. Nevertheless, the likelihood of banking crises would fall substantially which often enforce substantial costs not only on banks, but also on the rest of the economy. Similarly, reducing leverage does not simply shift these external costs of banking crises from the rest of the economy onto banks. Instead, lower leverage reduces the likelihood of crises in the first place and the costs might be avoided altogether (Miles, Yang & Marcheggiano, 2011). On the other hand, those who have argued against increasing share capital would be costly believe that debt can plays a significant or positive role in reducing frictions due to proper governance and asymmetric information. For instance, debt can serves as a “disciplining device” to prevent managers from wasting or diverting funds. That is to say that, short term debt, or long term debt when some of it needs to be renewed periodically, is said to provide “market discipline” because the fear that it might be withdrawn or not renewed leads managers to act more in line with the preferences of creditors, and even avoid taking excessive risk. However, the theoretical and empirical foundations of these claims seem weak, and that the models that are used to support them are actually not adequate for guiding policy regarding capital requirements. Conclusion This paper reviewed David miles speech on monetary policies and banking fragility in light of the UK economy. To a great extent, Miles view holds that since it is clear that increasing the share capital in the banking sector remain the best alternative to dealing with the financial shocks. It would result in a stage where it will be quite normal to have banks finance a much higher proportion of their lending using share capital that has been assumed in recent decades to be acceptable in addition to a change that brings a fourable environment for the economic growth. References Auerbach, A (2002) ‘Taxation and Corporate Financial Policy’, American Economic Review, Papers and Proceedings, Vol. 92, pp 67-178. Cheng, Y. and Green, C (2008) ‘Taxes and Capital Structure: A Study of European Companies’, The Manchester School, Vol. 76 (S1), pp. 85-115. David Miles, Jing Yang and Gilberto Marcheggiano (2011) Discussion Paper No. 31: revised and expanded version: Optimal bank capital External MPC Unit, Bank of England, Thread needle Street, London David Miles (2011) Speech: Monetary policy and banking fragility, the London School of Economics, 27 July 2011 Desai, A, Fritz Foley, C, and Hines, J (2004) ‘A Multinational Perspective on Capital Structure Choice and Internal Capital Markets’, Journal of Finance, Vol. 59, pp 2451-2487. Graham, J (2003) ‘Taxes and Corporate Finance: A Review’, Review of Financial Studies, Vol. 16, pp. 1075-1129. Kashyap, K, Stein, J, and Hanson, S (2010) ‘An Analysis of the Impact of ‘Substantially Heightened’ Capital Requirements on Large Financial Institutions’, Working Paper. Marco Pagano (2005) The Modigliani-Miller Theorems: A Cornerstone of Finance Centre for Studies in Economics and Finance, UNIVERSITY OF SALERNO ITALY Miller, Merton H. (1988), “The Modigliani-Miller Propositions After Thirty Years,” Journal of Economic Perspectives 2(4), 99-120. Modigliani, F, and Miller, M (1958) ‘The Cost of Capital, Corporation Finance and the Theory of Investment’. American Economic Review 48 (3): 261–297. Weichenrieder, A and Klautke, T (2008) ‘Taxes and the efficiency costs of capital distortions’, CESifo Working Paper, No. 2431. Read More