Bank capital ; Bank holding companies ; Securities ; Stock market

Michael C. Keeley

English

Research Papers in Economics

FRBSF WEEKLY LETTER
March 17, 1989
Banks' Cost of Capital
Bank and bank holding company (BHC) capital
regulation is becoming an increasingly important
tool to limitbank risk taking and thereby the risk
exposure of the deposit insurance system. More
capital relative to assets provides a greater cush-
ion to absorb any given loss and minimizes the
spillover to the deposit insurance fund. More-
over, increased capital reduces banks' incentives
to increase asset risk and thus to risk bankruptcy.
Thus, an increase in banking organizations' capi-
tal-to-asset ratios over time should reduce the
risk of bank failures and reduce the risk exposure
of the deposit insurance fund.
However, many bankers appear reluctant to is-
sue additional common stock, arguing that doing
so is very costly compared to raising funds from
other sources. This Letter examines evidence on
the stock market's reaction to the issuance of
various securities by BHC" to determine why
common stock might be a more costly source of
funds and what implications this has for the for-
mulation of capital regulations.
Capital regulation
Bank and BHC capital regulation was first
strengthened in December 1981 when objective
minimum standards were introduced in a depar-
ture from the subjective, peer-group type of
capital regulation used previously. In 1983, these
standards were extended to include the multi-
national BHCs and in 1985, a single minimum
standard was adopted for all BHCs, regardless of
size. More recently, the Board of Governors of
the Federal Reserve System and the other bank-
ing regulatory agencies adopted an even more
stringent, risk-based standard for banks and
BHCs as part of an international agreement
among the twelve leading industrial countries.
These new requirements became effective Feb-
ruary 15, 1989.
To meet these ever more stringent capital-to-asset
requirements, many banks and BHCs are having
to sell assets and/or incre?se capital. Banking
organizations can increase capital several ways:
by retaining a higher proportion of their current
earnings and/or by raising external capital
through the sale of common stock, preferred
stock, mandatory convertible debt, convertible
debt, or long-term subordinated debt. The ap-
proach taken by any given banking organization
will depend on which is the least costly and also
whether there is regulatory pressure to adopt one
particular approach. To the extent these two cri-
teria are in conflict, regulators need to determine
whether requiring a more costly approach to
raising capital is justified.
The stock market's reaction
The stock market's reaction to the issuance of
securities by banking organizations may provide
useful insights into the cost of issuing various
types of capital and the reasons why one type
might be more costly than others. A securities
issuance that imposes costs on a banking organi-
zation should affeCt the market's valuation of the
firm and lead to a fall in the firm's stock price.
Moreover, since the stock market reacts quickly
to new information, the effects of a new security
issuance on the market's valuation of a firm
likely will show up in the firm's stock price at the
time the security issuance is announced. Thus,
stock-price reactions to the announcement of a
security issuance provide information on the
market's assessment of the net costs to the issuer.
I have conducted a study of the stock-price reac-
tions to 155 securities issuances by 34 BHCs
from 1975 to 1986 using statistical techniques to
measure the valuation effects of the announce-
ment of the security issuance and to control for
other factors that also might have affected the
issuer's stock price on the day of the announce-
ment. The findings of that study, which were
published in the Winter 1989 issue of this Bank's
Economic Review, are summarized below.
Common stock issuance
Over the entire 1975-1986 period, BHCs' com-
mon stock prices fell on average by a statistically
significant one and one-half percentage points
when a new common stock i~suance was an-
nounced. Similar results have been found byFRBSF
Another possible explanation (which is not
necessarily inconsistent with the preceding ar-
gument) is that common stock issuance conveys
The Figure shows that during the post-1981
period, the stock-price effects of common stock
issuance were not negative for capital sufficient
banking organizations. In contrast, the effects
were negative for capital deficient organizations,
though they were somewhat less negative than in
the earlier period.
One interpretation of these results is that the
negative effects on capital deficient BHCs simply
reflect a diminution in the value of the deposit
insurance guarantee. According to this view,
capital sufficient BHCs would not experience
negative effects from issuing new stock since
their greater initial level of capitalization meant
that deposit insurance was not underpriced for
them.
2
o
3
-1
-4
-3
-2
4
Percent Change In
Stock Price
1982-1986
After New
Capital Guidelines
o Capital Deficient
• Capital Sufficient
1975-1981
Before New
Capital Guidelines
Different price effects
To address these concerns, it is useful to dis-
tinguish between the periods before and after the
change in capital regulation and between the
price effects on banking organizations under reg-
ulatory pressure to boost capital and the effects
on organizations that issued new common stock
voluntarily. The results of such a comparison are
displayed in the Figure. Banking organizations
under regulatory pressure toboost capital (de-
fined as BHCs not meeting the 1985 capital
standard in 1981) are labeled "capital deficient"
and all other BHCs are labeled "capital suffi-
cient."
Stock-Price Effects of
Common Equity Issuance
Third, the stock-price effects analyzed in this
study cover both the period before objective cap-
ital regulations were put in place beginning in
late 1981 and the period after the new regulations
were imposed. The market's reactions to new
common stock issuance might be very different
between the two periods. Thus, it may not be
possibleto infer much about the cost of common
stock issuance in the new regulatory environ-
ment from results that average the stock-price
reactions in the two periods. Similarly, even dur-
ing the post-1981 period,some issuances were
voluntary, while .others were the result of regula-
tory pressure. In theory, one would expect volun-
tary issuances to have very different price effects
than issuances required by the regulators.
Second, as mentioned above, one reason .for re-
quiring banks and BHCs to issue capital is to
reduce the risk exposure of the deposit insurance
fund. Banking organizations for which deposit
insurance is underpriced are receiving a valuable
subsidy, and their stock prices will reflect this.
Therefore, requiring them to raise additional cap-
ital will reduce the value of this subsidy and may,
as a result, cause their share prices to fall. Bank-
ers in this situation would view the issuance of
additional common stock as a costly way to raise
funds. However, this is hardly reason for bank
regulators toallow them to raise funds from
other, less costly sources, unless those other
sources commensurately reduce the risk ex-
posure of the deposit insurance fund.
On the surface, these results appear to support
bankers' contentions that raising capital in the
form of common stock is costly. There are, how-
ever, several difficulties in interpreting these
results in this simple manner. First, even larger
negative stock-price effects have been found for
industrial firms that voluntarily issue common
stock. Presumably, if there were less costly
sources of funds available to these industrial
firms, they would not have chosen voluntarily to
issue common stock.
other researchers. Moreover, the magnitude of
the dilution effects implied by these stock-price
declines is large; the value of BHCs' existing
shares declined by an amount equal to approx-
imately 30 percent of the value of the funds
raised. In other words, an issue that raised $100
million, for example, would have increased a
bank's net capital by only $70 million.information about a capital deficient BHC's earn-
ings prospects. Under the new capital guidelines,
the market can readily determine when a BHC is
under regulatory pressure to raise capital. Thus,
when a capital deficient BHC issues common
stock as opposed to other forms of capital, the
market may treat the issuance as a signal that the
regulators believe that such a BHC's earnings
prospects are not good. After all, if the BHC's
earnings prospects were good, the regulators
probably would allow it to issue securities such
as debt or preferred stock that require increased
future payouts from earnings.
In any event, these results do not suggest that
common stock is an inherently more costly
source of funds. Instead, for well-capitalized
BHCs, there appear to be no costs to raising
additional capital through common stock issu-
ance. In contrast, poorly capitalized BHCs find
common stock issuance costly because of their
financial condition.
Other securities
At the same time, however, there is evidence that
the issuance of other types of securities such as
straight subordinated (to deposits) debt, convert-
ible subordinated debt, and preferred stock does
not have negative stock-price effects. In fact, my
study found no negative effects for such securities
over the entire sample period, nor over the pre-
and post-1981 periods, nor for the capital defi-
cient and sufficient BHCs. Some analysts have
concluded from such results that common stock
is a more expensive form of capital.
One problem with such a conclusion is that
the literature on securities issuance by industrial
firms also does not find negative stock-price ef-
fects associated with debt and preferred stock is-
suance and yet industrial firms voluntarily issue
common stock. If common stock really were
more costly, industrial firms probably would not
issue common stock.
Another problem with the view that debt and
preferred stock are cheaper sources of protection
for the insurance fund is that even though these
securities technically are subordinated to depos-
its, over the period covered in my study, in fact,
the bank regulators did not always treat these
types of securities as subordinant in their hand-
ling of major bank failures. Specifically, in the
resolution of the Continental Illinois problem,
neither the debtholders nor the preferred stock
holders of the BHC suffered losses, even though
the common stock holders did. Consequently, the
market may have viewed debt and preferred
stock as implicitly insured. If so, there is no rea-
son to expect the issuance of debt and preferred
stock to diminish BHCs' stock prices.
A useful tool
The negative stock-price effects associated with
common stock issuance by BHCs with weak
capital positions help to explain why such
organizations resist regulatory pressure to issue
common stock to meet capital requirements.
However, the absence of negative price effects
for strongly-capitalized BHCs suggests that the
high cost of common stock for poorly-capitalized
institutions results from their financial condition,
not because common equity is inherently more
costly. Indeed, if capital regulation is having the
desired effect of reducing the risk exposure of
the deposit insurance fund, there is every reason
to expect negative stock-price effects for those
BHCs representing the greatest risks to the fund.
Michael C. Keeley
Research Officer
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board.ofGovernors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.Research Department
Federal Reserve
Bank of
San Francisco
Alaska Arizona California Hawaii Idaho
nevada Oregon Utah Washington
,

Banks' cost of capital

http://www.frbsf.org/publications/economics/letter/1989/el89-11.pdf

Banks' cost of capital

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics