Banks and Modigliani-Miller
By Arnold Kling
What about the Modigliani-Miller Theorem? Recall that this famous theorem says that a firm’s value as a business enterprise is independent of how it is financed. The debt-equity ratio determines how the risky cash flow from operations is divided among creditors and owners. But it does not affect whether the firm is fundamentally viable as an on-going concern. It seems to me that, as least as first approximation, the logic of this theorem should apply to financial intermediaries as well as other types of business. If not, we need some explanation as to why.
…many banks and other intermediaries now borrow short and lend long. The issue I am wrestling with is whether this maturity transformation is a crucial feature of a successful financial system. The resulting maturity mismatch seems to be a central element of banking panics and financial crises. The open question in my mind is what value it has and whether the benefits of our current highly leveraged financial system exceed the all-too-obvious costs.
Evidently some radiation from Mencius Moldbug has leaked into Harvard Yard.
As readers of this blog know, I have thought about such issues quite a bit. Below are a few points, in case Mankiw or his readers want to catch up.1. The way I think of Modigliani-Miller is that it creates a world where the structure of financial intermediation does not matter. There are risky projects, and there savers, and the savers have perfect information about the intermediaries’ assets and liabillities.
WIth my usual metaphor, think of the risky projects as fruit trees. Think of a financial intermediary, such as a bank, as having an investment in fruit trees that is partly financed by debt and partly financed by equity. Savers can fund fruit trees either directly (without the bank) or by purchasing the debt or equity of the bank. The Modigliani Miller theorem implies that savers will fund the same amount of fruit trees, regardless of what the bank does–in fact, regardless of whether the bank even exists. If the savers want to invest in 100 fruit trees, and they see that the bank has invested in 50 fruit trees, they will invest in 50 fruit trees on their own. If the bank boosts its investment to 80 fruit trees, savers will invest in just 20 fruit trees on their own.
2. Taxes and deposit insurance break the Modigliani-Miller theorem. The corporate income tax rewards banks (and other firms) for leverage, because interest is tax deductible. Deposit insurance rewards leverage, because funding with deposits means that the shareholders get the upside but the taxpayers get the downside. As Russ Roberts has pointed out, it seems to be the de facto policy of the government to bail out other creditors as well, even in cases where it allows shareholders to take a loss. This policy, too, rewards leverage.
3. Bankruptcy costs break the Modigliani-Miller theorem in the other direction. That is, if the only deviation from Modigliani-Miller is that there are deadweight losses (legal fees, loss of brand value) when a firm goes bankrupt, it makes sense to finance entirely with equity.
4. I am afraid that Modigliani-Miller is a really misleading way to think about financial intermediaries, particularly banks. The reality is that savers do not know much about the projects in which the intermediaries invest. In fact, a big function of financial intermediaries is to specialize in knowledge about the projects in which they invest. In this context, debt instruments amount to the bank saying, “Look, you have no idea what my fruit tree portfolio looks like, and you don’t want to take a share in the ups and downs of that portfolio. Fine, I’ll pay you a fixed interest rate, and the shareholders will deal with the ups and downs of the portfolio.”
5. Maturity transformation can, up to a point, work on the basis of diversification. As long as not too many of my long-term investments go bad at once, and as long as not too many of my short-term creditors refuse to roll over my liabilities at once, I can get away with it and make everyone better off than if I did no maturity transformation.
6. As I said in my macro lectures (see number 9), “The nonfinancial sector wants to hold risk-free short-term assets and issue risky long-term liabilities. To accommodate this, the financial sector does the opposite.”
As I said in the lectures, the financial sector does this by diversifying more effectively than individuals can and/or by evaluating and managing risks better than individuals can (the intermediary really studies the fruit tree market, while you and I are off doing other things), and, sometimes, by signaling that it is doing such things more than it really is. When banks are signaling that they are sounder than they really are, it can be pretty hard for savers to figure this out. Call this the problem of misleading signals.
7. One fundamental problem in financial regulation is that regulators, too, are often unable to penetrate misleading signals. Often, even the bank’s executives believe the misleading signals.
8. A second fundamental problem in financial regulation is that the regulators are also signaling. They are signaling that they are able to protect savers from having to worry about misleading signals from banks. The more that savers believe this, the less vigilant they become in trying to sort out misleading signals. Thus, regulator confidence creates a form of moral hazard. The more that the regulator convinces the public that it has things under control, the less likely that the public will take steps to keep things under control. If you claim that you have made a bank too regulated to fail, the more that the public believes you, the less likely it is that you are going to be able to keep the bank from acting recklessly–and failing.
I do not think that there is a perfect solution to all of this. If you go full-Monty libertarian and take away all government intervention, including deposit insurance, then you have to live with whatever ups and downs occur in people’s confidence in bankers’ signals. Banks will invest a lot more in signals, and some of that investment will be deadweight loss and some of it will be investment in signals that are downright misleading. On the other hand, if government does intervene, you get deadweight loss from banks trying to game the government. Either way, you get deadweight loss from banks gaming the system. They game the signaling system in a privatized system, and they game the government in a government-regulated system.
I think we have to settle for imperfect financial regulation. Once again, let me make a pitch for policies that make the financial system easy to fix, rather than hoping that we can make it impossible to break.