Journal of Economic Literature 2014, 52(1), 197-210

199

Myerson: Rethinking the Principles of Bank Regulation

lend their money to the bank at low interest 

rates.

Notice, however, that this reassurance 

was based on two distinct effects of equity. 

For any given level of risk in the bank’s 

investments, the probability of investment 

losses large enough to affect the depositors 

becomes smaller when the bank has more 

equity. But more equity also means that the 

owners who control the bank have more 

incentive to avoid risks of such large losses. 

That is, equity helps to solve moral hazard 

in banking.

Of course, a large bank may have many 

small shareholders who are not actively 

involved in the bank’s management, but the 

term equity denotes the equal proportionate 

sharing of profits among all owners, includ-

ing large investors who can actively oversee 

management. Plus, any systematic failure to 

serve equity interests could open the possi-

bility of a take-over bid. So it is not unreason-

able to identify the interests of a bank with 

the interests of its equity owners.

The waves of bank runs that brought on 

the Great Depression in the 1930s led to 

the creation of government deposit insur-

ance programs in America and elsewhere. 

Deposit insurance effectively responded to 

the possibility that widespread fears of bank 

failure could create a self-fulfilling prophecy, 

as depositors would run to withdraw their 

deposits before the bank failed because of 

an inability to quickly liquidate all its invest-

ments. With deposit insurance, however, 

depositors became less concerned about 

how much equity their bank had in its total 

investments, and so banks could borrow at 

low interest rates even with less equity. But 

when creditors are publicly insured, bank 

default risk becomes a public problem. Thus, 

the requirement that banks should have ade-

quate equity has become a responsibility of 

public regulators.

But now we come to the critical point of 

confusion that Admati and Hellwig compare 

to Hans Christian Anderson’s story of a 

deceived emperor whose lack of clothes 

went unacknowledged. When individual 

depositors bore the risks of bank failure, 

people could see clearly enough that they 

should not deposit funds in a bank with too 

little equity. But when the responsibility for 

insuring depositors against bank failures has 

been transferred to the government, then 

equity requirements can be portrayed as a 

technical regulatory subject that only experts 

can understand, and banks can hire the most 

experts to address this subject.

Persuasive voices in regulatory debates 

have argued that equity is expensive for 

banks, and that requiring more equity would 

increase their costs of lending and cause a 

decline of economic investment and growth. 

With this logic, the levels of bank equity have 

been allowed to decline over the twentieth 

century until, in the run-up to the financial 

crisis of 2008, many large banks in Europe 

and America could finance their assets with 

3 percent or less equity. When losses put this 

thin layer of equity at risk, the result was a 

global financial meltdown.

But like the boy who finally observed that 

the emperor had no clothes, Admati and 

Hellwig offer straightforward and convincing 

testimony to contradict all these arguments 

for minimizing bank equity. Complicated 

arguments call for complicated counterar-

guments, but Admati and Hellwig use their 

expertise in economic analysis to identify the 

simplest rebuttal.

A key point in this discussion is the famous 

insight of Modigliani and Miller (1958) that, 

under some basic assumptions, the sum of 

the total value of a corporation’s equity to its 

owners plus the total value of its debt to its 

creditors should be equal to the total value of 

its income-earning assets.

1

 This result tells us 

1 

Standard accounting estimates of equity value are cal-

culated to make this equation an identity, but Modigliani 

and Miller’s argument applies to actual market values, 

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Journal of Economic Literature, Vol. LII (March 2014)

200

that the total cost of issuing debt and equity 

to finance any given portfolio of investments 

should not depend on how much is debt 

and how much is equity. Under these basic 

assumptions, then, changing equity require-

ments should not affect the total cost of bank 

lending at all. Modigliani and Miller tell us 

that, at least for banks that are organized 

as corporations, profitable new investments 

could be financed by selling new shares of 

stock in the bank as well as by borrowing 

more money.

A good economic theorist can find plenty 

of exceptions to the simplifying assumptions 

of this Modigliani–Miller theorem. But the 

primary reason the cost of financing invest-

ments can sometimes depend on the mix 

of debt and equity is that, at times, another 

party bears the difference in costs. In par-

ticular, when the government is (implicitly 

or explicitly) insuring a bank’s creditors, 

then increasing the fraction of debt financ-

ing can increase the value of this insurance 

from the government. In this case, increas-

ing debt may make the bank’s owners bet-

ter off at no cost to the creditors, but the 

bank’s gains would be at the expense of the 

tax-paying public, which is bearing risks that 

private investors would not accept without 

being paid a greater interest premium. Then, 

if tighter equity requirements would prevent 

the bank from making some investments, 

these would only be investments that private 

investors would have refused without subsi-

dized government insurance.

Thus, Admati and Hellwig argue, although 

equity may indeed seem expensive to a bank, 

it is only because public insurance enables 

them to borrow at low rates that do not 

properly respond to the greater risks that 

their creditors must bear when the bank has 

less equity.  When the cost to the public of 

showing that an arbitrage opportunity would exist if two 

firms with the same prospective income streams had dif-

ferent total values of their equity and debt.

providing this insurance is properly taken 

into account, the total social cost of the 

investment is not increased by requiring 

more of it to be financed by equity.

There are other exceptions to the 

Modigliani–Miller theorem that are worth 

mentioning. Myers and Majluf (1984) 

argued that, when the managers of a firm 

decide whether to finance new investments 

by borrowing money or by selling new equity 

shares at any given price in the stock market, 

the managers will be more likely to choose to 

sell new equity when they have adverse pri-

vate information that suggests that the mar-

ket has overvalued their stock. So the public 

may rationally take a firm’s decision to issue 

new equity as bad news about the firm, and 

the price of its stock should be reduced to 

take account of this adverse inference. This 

Myers–Majluf effect can indeed make equity 

financing more expensive than debt for the 

current owners of the firm. But notice that 

this adverse inference occurs only when a 

firm’s decision to raise capital by selling new 

equity shares depends on its managers’ pri-

vate information about the profitability of 

their business. The Myers–Majluf adverse 

inference would not apply when a regulator 

requires the firm to sell new equity shares 

based on information that is publicly avail-

able. Thus, a bank’s cost of raising new 

equity may actually be less when new shares 

are issued under a transparent regulatory 

requirement than if the same shares were 

issued by a discretionary decision of its man-

agement. This point by itself may be a good 

reason for regulating banks’ equity based on 

transparent public information.

Taxes can provide one other basic reason 

why the profitability of investments could 

depend on the mix of debt and equity that 

are used to finance them, if the tax laws treat 

interest payments to creditors differently 

from dividend payments to shareholders. 

Admati and Hellwig urge reform of current 

tax rules that tend to subsidize debt over 

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