Randall J. Pozdena

English

Research Papers in Economics

FRBSF WEEKLY LETTER
June 20, 1986
Leverage And Double Leverage In Banking
Banking firms, like other corporate entities,
finance their activities by issuing debt and equity
securities. The greater the ratio of debt-to-equity
used in fina.nCingthe firm, the more the firm is
said to be "leveraged."
In most industries, firms are free to determine
their own degree of leverage, disciplined only
by market forces. This is not true in the banking
industry where the financial structure of a bank-
ing firm is seen to have important public policy
implications. In particular, because a large pro-
portion of a bank's debt consists ofdeposits, reg-
ulators wish to ensure that banks maintain
adequate equity or "capital" to protect deposi-
tors against a decline in the value of the bank's
assets. Regulators have a special interest in
maintaining public confidence in deposits
because deposits make up the bulk ofthe
nation's money supply.
Regulators have been concerned in recent years
about the adequacy of bank capital and most
recently have revised bank capital standards.
The purpose'of this Letter is to review the nature
of bank leverage in light of the broader theory of
the optimal financial structure ofthe firm. As we
shall see, this helps in understanding problems
encountered in imposing minimum capital stan-
dards on financial institutions.
Theory of leverage
The effect of increased reliance on debt in a cor-
poration has two components. First, increased
leverage raises the expected return (earnings per
share) to shareholders, tending to make those
shares more valuable. Second, increased
reliance on debt weakens the firm's ability to
survive fluctuations in the value of its assets
without default and subsequent bankruptcy.
These two components of the effect of increased
leverage have offsetting effects on the price per
share of the firm's equity. Indeed, economists
Franco Modigliani and Martin Miller demon-
strated that, in a simplified theoretical frame-
work, the effects would be exactly offsetting. The
value of shares and, hence, the value of the firm,
should not vary with the degree of leverage
employed. Thus, a firm with a given portfolio of
assets should theoretically be unable to make its
shareholders better off simply by manipulating
the degree of leverage.
Leverage and taxes
There is some debate over whether this so-called
"invariance proposition" still holds when a
major distorting factor such as tax policy
intrudes. In particular, interest payments on debt
are deductible against corporate income
whereas dividend distributions and retained
earnings are not. Some analysts argue, therefore,
that shareholders would prefer a high leverage
strategy because such a strategy would "shield"
more of the firm's income from taxation and
thereby increase shareholders' after-tax earnings
prospects and hence, their wealth.
It can be argued, however, that these advantages
of debt at the corporate level are offset by disad-
vantages at the level of personal taxation, where
the proceeds from equity ownership receive
preferential treatment compared to interest
income. (That is, capital gains are taxed at a rate
lower than interest income.) The result is that
debt and equity may well have different "clien-
teles." For individuals facing high personal tax
rates, the after-tax cost disadvantages of equity
at the corporate level are more than offset by its
advantages at the personal level. The opposite is
true for individuals facing low tax rates.
The quantity of debt and equity willingly held by
the marketplace and the equilibrium yield will
be determined by the relative strength ofthe
demand by the two clienteles. As Merton
Miller has pointed out, this "clientele effect"
will determine the relative shares of debt and
equity for the economy as a whole, but not the
optimal leverage for the individual firm. Man-
agers therefore can make different decisions
about leverage without adversely affecting
shareholder wealth. This may explain why, at
least among nonfinancial corporations, we
observe the successful co-existence of both
highly leveraged and all-equity firms.FRBSF
Leverage in banking
Such clearly is not the case among financial
intermediaries____._ allof which are highly lever-
aged. This observation is, at least partly, defini-
tional. Financial intermediaries are firms that
have specialized in converting one form of
financialliabilityto another.They thus issue sig-
nificant quantitiesof debt. It follows, therefore,
thaHruefinancial intermediaries~.banks, sav-
ings and loan associations, consumer finance
companies, and so on - will tend to be more
highly leveraged than nonfinancial corporations.
Indeed, equity representsonlyabout5 percent
ofthe total sources of funds for banks and thrifts
and 15 percent for consumerfinance com-
panies, against over 70 percent fornonfinancial
corporations.
Simply distinguishingthis set of institutions as
highly leveraged does not mean that the invar-
iance proposition no longer holds. Firms in the
business ofmaking loans could be unleveraged
and still competewithfinancial intermediaries.
Indeed,all-equity enterprises such.<ls mutual
funds coexist with financia.l intermediaries in
loan markets. Why then dobank regulators
today continually struggle to keep le\ferage from
increasing stillfurther? .If the invariance proposi-
tion truly held in the case ofbanking,the cost
(in terms of shareholder wealth) of complying
with regulatory capital. standards would be zero
and such a struggle would not persist.
Depositprotection and leverilge
One possible explanation for .the apparent viola-
tion ofthe invariance proposition .is depositor
protection policy, wherebyholders of deposit
debt are protected from risk either explicitly-
through deposit insurance schemes - or
implicitly through the actions orbanking agen-
ciesthat have theeffector protectingdebt~
holders, insured or not. To the extent thatsuch
protection is available to banks at <lcost lower
than its expected insurance value, banks can
increase their expected earnings (and share-
holder wealth) by increasing their use of such
debt.
This hypothesized relationshipbetween deposit
protection and leverage is supported by the data
(see Chart). Bank debt-to-equityratios climbed
sharply immediately after the introduction of
deposit insurance in 1933 and· fell backonly
when capital regulation was pursued inearnest
in the early 1950s. Since then, debt-to-equity
ratios have risen steadily asthe degree of deposit
protection has grown.
The notion that deposit protection induces
increased leverage also finds support in the fact
that leverage is typically greater in depository
intermediaries than in nondepository intermedi-
aries such as consumer finance companies and
insurance companies. These other financial cor-
porations typically rely three to five times more
on equity than depository intermediaries such as
banks and thrifts.
Data on the market value ofthe shares in finan-
cial corporations provide additional support.
Despite the fact that some banking and thrift
institutions have portfolios that are "under
water" in terms of market value (that is, their lia-
bilities exceed the market value of their assets),
their shares continue to have positive market
value. An unreported asset - deposit protection
- could account for this phenomenon.
Regulation of bank capital
The strength of existing incentives to increase
leverage is evidenced by the difficulties regula-
tors encounter in regulating capital. Numerous
factors have made capital standards less binding
in practice than in theory. One factor is the
mechanism employed by regulators to deter-
mine capital standards. Without any hard theory
to guide them, regulators have employed peer
group analysis to devise capital standards. While
such a mechanism permits identification of
banks whose leverage is much greater than the
norm for comparable institutions, it does not
protect against gradual increases in leverage for
the peer group as a whole.
There also has been a legitimate debate as to
precisely what constitutes "capital" for the pur-
poses sought by regulators, namely, to protect
depositors from the loss of their funds and
thereby protect the banking system from the
consequences of runs and failures. For example,
because subordinated debt (that is, debt obliga-
tions that are subordinate to a bank's obligations
to its depositors) in theory protects deposit debt
in the event that the value of a bank's assets
deteriorates, banks have argued (sometimes suc-
cessfully) that the regulatory definition of "capi-
tal" could include subordinated debt in addition
to true equity.
This expanded definition raises an important
question, however. Why would banks wish toa 400
1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1984
issue subordinated debt rather than equity since
- according to the invariance proposition at
least - equity and (unprotected) debt would be
equally costly? One possible answer is that the
protection afforded deposits "spills over" onto
other forms of bank debt as well. That is, the
marketplace perceives subordinated bank debt
as enjoying some default protection as well,
since regulators typically close banks before
such debt is jeopardized. The effects of this pro-
tection argue that regulators should not include
subordinated debt in capital adequacy stan-
dards.
is the same whether simple or double leverage
internal financing techniques are employed.
Double leverage financing is particularly inter-
esting because it takes place despite other super-
visory policies that would be expected to favor
simple leverage. In particular, bank supervisors
limit the payout of dividends by banks. In the
case of double leverage finance, it is precisely
these dividend flows that must be "upstreamed"
to service the BHC debt. In contrast, if simple
leverage were used, the revenues ofthe bank
would have flowed out as interest payments to
the BHe. Bank supervisors consider interest pay-
ments an expense and do not impede their flow.
(Double leverage can be detected by examining
the balance sheets ofthe bank and its parent
holding company. Specifically, ifthe parent
BHC has less equity capital than the bank it
owns, some ofthe BHC debt must have been
downstreamed to the bank as equity.)
The rationale of double leverage
Although BHC shareholders should be indif-
ferent bet~een single and double leverage tech-
niques on the basis of wealth considerations,
they appear to prefer the double leverage tech-
nique. By employing double leverage, BHC
management can use debt to satisfy capital ade-
quacy standards that are more stringent for
banks than BHCs.
Deposit Insurance And Trends In Leverage
Percent Percent
100
I
1600
90
Start of
80 Federal
Deposit
70 Insurance
1200 (1933)
60 ,-_.......
50 ,
r·"
-'''"'\ ,
40 '.' J%Deposits Insured
-e 800
30
20
10
Bank holding companies and leverage
The bank holding company (BHC) form of bank-
ing organization also can make it difficult for
regulators to maintain desired leverage standards
in banking. A bank holding company is a corpo-
ration that issues its own debt and equity
securities and that invests the proceeds in the
debt or equity of a subsidiary bank.
Since simple leverage gives the BHC freer access
to the revenues of the subsidiary bank, there is
less risk of debt-servicing or default problems.
The fact that BHC shareholders are willing to
expose themselves to greater risk in exchange
for avoiding capital standards supports the
notion that capital standards are costly to bank-
ing organizations.
This process of using funds is referred to as
"downstreaming." When the parent BHC issues
debt to acquire the debt of the subsidiary bank,
the phenomenon is referred to as "simple le-
verage." When the proceeds of the parent debt
issue are downstreamed as equity, the practice is
referred to as "double leverage." To an outside
investor, leverage ofthe consolidated enterprise
In conclusion, it appears that deposit protection
causes the invariance proposition to be violated
in the banking industry. It induces managers of
banking firms to resist capital regulation and sets
the stage for what is likely to be a long-lived
struggle between banks and regulators of bank
capital.
RandallJ.Pozdena
Opinionsexpressed in this newsletterdo not necessarily reflecttheviewsofthe management ofthe Federal Reserve BankofSan
Francisco,orofthe BoardofGovernorsofthe Federal Reserve System.
Editorialcommentsmaybeaddressedtotheeditor(GregoryTong)ortotheauthor....FreecopiesofFederal Reservepublications
can beobtained from the Public Information Department,Federal Reserve Bankof San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.uo~6U!450m 40~n U060JO 0pOA0U
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Amount
Outstanding
5/21/86
Change
from
5/14/86
Change from 5/22/85
Dollar Percent!
Loans, Leases and Investments1 2 202,276 190 10,197 5.3
Loans and Leases1 6 183,412 185 9,943 5.7
Commercial and Industrial 52,386 - 489 - 149 - 0.2
Real estate 66,968 244 3,881 6.1
Loans to Individuals 38,922 - 48 4,843 14.2
Leases 5,627 - 8 266 4.9
U.S. Treasury and Agency Securities2 11,028 12 - 564 - 4.8
OtherSecurities2 7,836 - 7 817 11.6
Total Deposits 200,491 -1,318 7,644 3.9
Demand Deposits 48,297 -1,646 4,464 10.1
Demand Deposits Adjusted3 33,792 - 650 - 6,269 -15.6
OtherTransaction Balances4 15,737 - 20 2,621 19.9
Total Non-Transaction Balances6 136,457 347 560 0.4
MoneyMarket Deposit
Accounts-Total 46,440 440 3,063 7.0
Time Deposits in Amounts of
$100,000or more 36,234 - 135 - 2,162 - 5.6
Other Liabilities for Borrowed MoneyS 23,854 - 405 552 2.3
Two WeekAverages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)/Deficiency(-)
Borrowings
Netfree reserves (+)/Net borrowed(-)
Period ended
5/19/86
28
41
13
Period ended
5/5/86
15
39
55
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
3 Excludes U.S. governmentand depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephone transfers
S Includes borrowingvia FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
7 Annualized percentchange

Leverage and double leverage in banking

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Leverage and double leverage in banking

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