## Low Risk Anomaly in Banking Industry and Its Implications Friday, 9 February, 2018

**Related mainly to #7 - Volatility Effect in Stocks - Long-Only Version:**

**Authors:** Baker, Wurgler

**Title: **Do Strict Capital Requirements Raise the Cost of Capital? Bank Regulation and the Low Risk Anomaly

**Link:** https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2967265

**Abstract:**

Traditional capital structure theory in frictionless and efficient markets predicts that reducing banks’ leverage reduces the risk and cost of equity but does not change the overall weighted average cost of capital (and thus the rates for borrowers). We test these two predictions. We confirm that the equity of better-capitalized banks has lower beta and idiosyncratic risk. However, over the last 40 years, lower risk banks have higher stock returns on a risk-adjusted or even a raw basis, consistent with a stock market anomaly previously documented in other samples. The size of the low risk anomaly within banks suggests that the cost of capital effects of capital requirements is large enough to be relevant to policy discussions. A calibration assuming competitive lending markets suggests that a binding ten percentage-point increase in Tier 1 capital to risk-weighted assets more than doubles banks’ average risk premium over Treasury yields, from 40 to between 100 and 130 basis points per year, and presumably raises rates for borrowers to a similar extent.

**Notable quotations from the academic research paper:**

"The instability of banks in the financial crisis has reignited debates about capital requirements. One of the ongoing concerns has been that capital requirements might affect banks’ overall cost of capital, and therefore lending rates and economic activity. Many bankers appear to prefer lower capital requirements. They argue that because equity is more expensive than debt, more of it clearly raises the overall cost of capital.

Economists, on the other hand, often view this argument as a fallacy. The textbook Modigliani-Miller logic is articulated by, for example, Admati, DeMarzo, Hellwig, and Pfleiderer (2011): “[B]ecause the increase in capital provides downside protection that reduces shareholders’ risk, shareholders will require a lower expected return to invest in a better capitalized bank”.

Real capital markets contain frictions and inefficiencies that challenge the Modigliani-Miller assumptions, however, so the relevance of the frictionless-irrelevance argument is not so clear. Many of these frictions have been studied, but there has been surprisingly little direct evidence on the basic proposition that reduced leverage reduces the cost of equity. In this paper, we study empirically how leverage has related to the risk and cost of bank equity and, in turn, to the overall cost of capital.

We are especially motivated by the possible interaction of capital requirements and the “low risk anomaly” within the stock market. That is, while stocks have on average earned higher returns than less risky asset classes like corporate bonds, which in turn have earned more than Treasury bonds, recent research emphasizes that the basic risk-return relationship within the stock market has historically been flat, if not inverted.

We use a large sample of historical U.S. data and proceed to test the two steps in the traditional argument. First, we relate bank equity betas estimated from CRSP to leverage ratios from quarterly reports. Second, we relate realized returns on equity to bank equity betas. We also replace beta with idiosyncratic risk. The two steps together then allow us to calibrate the effect of increased capital requirements on the cost of equity and, under certain assumptions, the overall cost of capital. We reach similar conclusions when we relate capital to returns directly over the sample with good data on risk-adjusted capital ratios.

We confirm that bank equity risk is sharply increasing in leverage. This is not surprising, and our work here extends that of Kashyap, Stein, and Hanson (2010). When capital is measured by the Tier 1 capital to risk-weighted assets ratio, the portfolio beta of the least-capitalized banks is 0.93 while the portfolio beta of the most-capitalized banks is 0.50. Higher capital ratios also predict lower idiosyncratic risk. Even this relatively large difference in beta is attenuated by two factors. Banks with riskier assets may choose to have larger capital cushions. This endogenous selection reduces the slope between beta and observed capital ratios.

Does a reduction in beta translate to a reduction in the cost of equity? **The answer from 40 years of U.S. stock returns is no. The low risk anomaly is actually a bit stronger within banks than other firms. High-beta banks returned less than low-beta banks, even on a raw basis, and even in a period of mostly rising equity markets. **Value-weighted returns are, on average, 16 basis points per month higher for a portfolio of the lowest three beta deciles than for a portfolio of the highest three beta deciles. The spread between low and high idiosyncratic risk portfolios is 6 basis points per month. These effects are not mediated by capitalization. Controlling for a size factor increases the risk-adjusted differences, especially for idiosyncratic risk portfolios. More simply, beta is positively correlated with capitalization while idiosyncratic risk is negatively correlated, yet both risk types are negatively related to average returns.

Putting the pieces together, the data suggest that more conservative capital structures reduce the risk of equity but may increase its cost, and the overall cost of capital, by bringing the low risk anomaly into play. To assess magnitudes, we focus on the beta anomaly and estimate how the overall cost of capital for a bank would have changed over this period given the hypothetical ten percentage-point increase in Tier 1 capital to risk-weighted assets experiment in Kashyap et al. (2010). A benchmark estimate of the pretax weighted average cost of capital for a typical bank implied by the Capital Asset Pricing Model over our sample period is 40 basis points per year above the risk-free rate. By reducing equity betas, banks with a full ten percentage point increase in Tier 1 capital would have added between 60 and 90 basis points to this spread, which would more than double the weighted average cost of capital over the risk-free rate to between 100 and 130 basis points. In a competitive lending market this would have translated to a similar increase in rates faced by borrowers."

**Are you looking for more strategies to read about? Check http://quantpedia.com/Screener**

**Do you want to see performance of trading systems we described? Check** **http://quantpedia.com/Chart/Performance**

**Do you want to know more about us? Check** **http://quantpedia.com/Home/About**

## Recent posts

- Size, Value and Equity Premium Waves
- SSRN Platform Upgrade
- A New Filter Fields in Quantpedia Screener
- An Extensive Test of Market Timing Strategies in the Gold Market
- Predictability of Betting-Against-Beta Factor
- Announcing QuantConnect & Quantpedia Cooperation
- A Very Influential Paper About Tether-Bitcoin Relationship (Manipulation?)
- Arbitrage Opportunities in Cryptocurrency Markets
- The Impact of Volatility Targeting on Equities, Bonds, Commodities and Currencies
- Returns to Investors in Initial Coin Offerings