Streetwise Professor

Harry D’Angelo and Rene Stulz have an interesting paper about bank leverage.  It makes a simple point.  Banks’ liabilities-notably, deposits-are someone else’s asset. That asset provides a benefit, namely liquidity, that depositors can’t realize by trading in capital markets, due to some friction.  This intermediation is what makes banks special.  As a result, depositors are willing to hold bank liabilities in exchange for a lower return than bank assets. Banks therefore have an incentive to create these liabilities-that is, to leverage up-to the maximum extent possible, in order to capture as much of this liquidity premium as possible.  This leveraging is a good thing, because it supplies an asset that is highly valued by those who incur high costs to access capital markets directly.

In the D’Angelo-Stulz model, bank equity is the capitalized value of this below market borrowing rate/liquidity premium.  If the liquidity premium is modest, the  supply of liquid claims results in a high debt to assets ratio.  Again, this high leverage is a good thing, because it is the consequence of the efficient supply of intermediation.  Banks access the capital market effectively engage in a form of asset transformation that generates value: those who cannot access the capital markets, or at least not as efficiently, cannot engage in this asset transformation, and they are willing to pay banks who can.  Through diversification and risk management, banks can engage in asset transformation that is valued by depositors.

This paper is most useful as a corrective to the rather annoying Admati et al “Bankers’ New Clothes” arguments that banks are excessively leveraged and should therefore be subjected to far more rigorous capital requirements, e.g., 25 percent equity.   Admati et al rely heavily on Modigliani-Miller type arguments, and D’Angelo-Stulz show that high leverage can be efficient when there is a single deviation from MM assumptions.  Bank debt (at least some forms of it-more on this below) provides a valuable device in the presence of a friction, and therefore issuance of this debt (in lieu of equity) is socially beneficial.

That said, there are some issues with the paper.

First, the formal model is very rudimentary.  It posits that those without access to the capital market are willing to pay an exogenously specified premium for bank liabilities that offer liquidity, i.e., guaranteed purchasing power.  But willingness to pay does not determine the equilibrium price of liquidity.  In a competitive banking market, the equilibrium price of liquidity is determined by the cost of producing it as well.  This is not modeled in the paper.  The marginal cost of engaging in intermediation/asset transformation must be upward sloping in order for banks to earn producer surplus (which, when capitalized, would be the value of bank equity).

Presumably, equity is one of the means by which banks are able to engage in asset transformation that provides reliable liquidity to those holding bank liabilities.  In essence, equity is a means of bonding contractual performance (a point I learned from reading Yoram Barzel years ago).  In the banking context, equity provides a cushion that ensures that depositors will be able to realize the face value of their claims at will-which is the essence of liquidity.  Thus, the reliability of the liquidity banks supply, and hence the premium that depositors are willing to pay, depends on the amount of equity (as well as on the asset side of bank balance sheets).  The paper does not address this interaction, taking equity value as a pure residual value driven by an exogenous liquidity premium that does not depend on bank equity.

Second, although deposits that provide liquidity to investors without ready access to the capital market are one part of bank leverage, banks, and especially systemically important ones, borrow in other ways, and the resulting liabilities do not have the same money-like characteristics as deposits.   The paper does not explain the entire capital structure of banks.  Indeed, it predicts that banks should be financed almost exclusively by the issuance of money-like liabilities.  They aren’t, so the paper doesn’t explain why banks issue debt that does not provide liquidity benefits instead of equity.  (Perhaps it could be argued that banks provide liquidity indirectly, e.g., by issuing corporate paper that is purchased by money market funds which provide money-like claims to investors.  But this still doesn’t explain the issuance of longer term debt.)

Third, this analysis relates primarily to commercial banks that issue deposits.  What about investment banks?  They are highly leveraged, and it’s not so clear that their liabilities offer the kinds of liquidity benefits that drive the results in the paper.  (Theories that argue that banks are too highly leveraged because of deposit insurance subsidies or access to central bank liquidity (at subsidized rates) don’t apply to investment banks either, because those didn’t have access to deposit insurance of central bank liquidity support.)

Fourth, the paper discusses systemic risk, but this discussion is a little glib.  Debt that provides valuable liquidity services under normal circumstances is fragile, and susceptible to runs.  When runs occur, money-like bank liabilities do not provide liquidity.  Presumably, this affects the liquidity premium, which means that it is unclear that banks issue too much debt.  But the paper can’t really address this question because the value of liquidity is specified exogenously.

All this said, the paper is still valuable because it makes an important point.  Existing theories of banks posit that banks are leveraged because debt addresses some sort of agency or information problem.  These are essentially supply-side factors. The D’Angelo-Stulz theory identifies a demand-side driver of bank leverage.

Bank leverage is a big issue now, with Basel III and Brown-Vitter.  Good policy regarding leverage (and hence, capital requirements) requires an understanding of its costs and benefits. Calling attention to the demand for bank liabilities, and the benefits they provide, is an important contribution to such an understanding.