Does Stricter Capital Requirement Raise the Cost of Capital of Banks? A Theoretical and Empirical Study of Banks in the US

Zhuolu Gao

Student thesis: Master thesis

Abstract

This thesis examines the impacts of increased capital requirement on the cost of capital of banks. We revisit the work by Baker and Wurgler [2015] and Dick-Nielsen et al. [2019] that propose different models to measure the cost of capital and then investigate the impacts of the heightened capital requirement on banks. In the former study, the cost of equity is measured by the CAPM which is adjusted by a low risk anomaly. Meanwhile, the debt is assumed to be riskless. We reproduce the tests and find the stricter capital requirement will lead to a significant increase in the total cost of capital in banks when applying this approach. We further relax the riskless debt assumption to include the risk of debt in the modeling framework. After this modification, we find the predicted increase in the total cost of capital using the original approach is too large. In the latter study by Dick-Nielsen et al.[2019], the cost of equity is measured by the implied cost of capital and the cost of debt is modeled through the interest expenses of banks. Then the regressions of cost of equity, cost of debt and total cost of capital on the capital ratio are performed. We reproduce the tests and find the stricter capital requirement will lead to a large decrease in the cost of equity and a moderate decrease in the cost of debt. These effects will finally balance out which means the total cost of capital will not increase significantly. We also extend this approach by an additional regression of implied cost of capital on the multiplicative inverse of capital ratio, rather than on the capital ratio. The proposed regression predicts a much smaller decrease in the cost of equity due to the same amount of increase in the capital ratio, compared to the original regression. This result indicates that the estimation of the change in the total cost of capital might be understated in the original approach. From the two proposed methods, we have a consistent conclusion that the stricter capital requirement will lead to a moderate increase in the total cost of capital for banks with the current level of leverage.

EducationsMSc in Advanced Economics and Finance, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2020
Number of pages89
SupervisorsDavid Lando