Bankers like to complain about Basel III capital rules. Among other things, they argue that the rules make construction lending more expensive. A nice summary of those rules notes:
In a pure Modigliani-Miller (MM) world, where capital structure is irrelevant to corporate valuation, this argument doesn't make sense. While debt is cheaper than equity, firms with less leverage are less risky than firms with more leverage, and so as the amount of debt used falls, the return on equity investors require also falls.
But while MM is helpful for thinking about capital structure, it makes some unrealistic assumptions. The most important MM assumption for thinking about capital and banks involves the cost of financial distress. MM in its purest form assumes the problem away--that debt will always be repaid, and so costs arising from potential default are irrelevant. One of the current presidential candidates shows that this assumption is problematic. When lenders (in this case, those who lend money to banks, such as depositors) think there is a chance they will not be repaid, they add a default premium to the cost of debt, and hence discourage leverage beyond some critical point. Thus the market disciplines the issuance of debt.
Yet for banks who rely entirely on deposits for funding, the MM assumption about the absence of default costs is realistic, because deposits are nearly all guaranteed by FDIC (the exception is corporations who briefly deposit money beyond the FDIC maximum for the purpose of paying workers). Banks (except for those that have bond financing as well as deposits) face less market discipline, and so get debt more cheaply than other businesses. Let me pause here to note that to me the benefits of deposit insurance have demonstrably outweighed the costs.
To return to the major point, however: for banks that rely on deposits for funding, higher capital requirements do indeed raise costs, because they limit the amount of subsidized debt they are permitted to use. For those of us worried about an absence of new construction in housing, this is a problem, because while Basel III does raise cost, it is doing so by attempting to prevent banks from avoiding market discipline. In other words, we are now probably closer to a world in which banks pay a more efficient price for funding construction loans than we were before. And compared to what we are used to, that price is expensive.
I would very much welcome other thoughts about this.
As part of the standardized approach, the final rule requires banking organizations to assign a higher risk weight of 150% to any high-volatility commercial real estate (HVCRE) exposure, defined as “a credit facility that finances or has financed the acquisition, development, or construction (ADC) of real property.”This means that lenders must put more capital behind construction loans than other types of loans. Bankers argue that because capital (in the form of paid-in equity and retained earnings) gets paid after debt, it requires higher returns than debt, and therefore higher capital requirements lead to higher lending costs.
In a pure Modigliani-Miller (MM) world, where capital structure is irrelevant to corporate valuation, this argument doesn't make sense. While debt is cheaper than equity, firms with less leverage are less risky than firms with more leverage, and so as the amount of debt used falls, the return on equity investors require also falls.
But while MM is helpful for thinking about capital structure, it makes some unrealistic assumptions. The most important MM assumption for thinking about capital and banks involves the cost of financial distress. MM in its purest form assumes the problem away--that debt will always be repaid, and so costs arising from potential default are irrelevant. One of the current presidential candidates shows that this assumption is problematic. When lenders (in this case, those who lend money to banks, such as depositors) think there is a chance they will not be repaid, they add a default premium to the cost of debt, and hence discourage leverage beyond some critical point. Thus the market disciplines the issuance of debt.
Yet for banks who rely entirely on deposits for funding, the MM assumption about the absence of default costs is realistic, because deposits are nearly all guaranteed by FDIC (the exception is corporations who briefly deposit money beyond the FDIC maximum for the purpose of paying workers). Banks (except for those that have bond financing as well as deposits) face less market discipline, and so get debt more cheaply than other businesses. Let me pause here to note that to me the benefits of deposit insurance have demonstrably outweighed the costs.
To return to the major point, however: for banks that rely on deposits for funding, higher capital requirements do indeed raise costs, because they limit the amount of subsidized debt they are permitted to use. For those of us worried about an absence of new construction in housing, this is a problem, because while Basel III does raise cost, it is doing so by attempting to prevent banks from avoiding market discipline. In other words, we are now probably closer to a world in which banks pay a more efficient price for funding construction loans than we were before. And compared to what we are used to, that price is expensive.
I would very much welcome other thoughts about this.
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