The Optimal Capital Structure of Depository Institutions

We derive here a fundamental model for the capital structure of depository institutions. The derivation centres on the basic Modigliani-Miller methodology, but instead of using a constant EBIT, as classically done for corporate firms, it implements a variable one, which hinges on the interest earnings from the asset-based loans made to the borrower. Following this, the effect of risk and credit spreads of both, the lender and borrower, are introduced and the impact of leverage on certain basic ratios, in particular the return on equity, is assessed. The outcome of this work is twofold. Firstly, it highlights some of the main differences that exist between the treatment of the capital structure of corporate firms and depository institutions. And, secondly, it demonstrates that the optimal capital structure of a depository institution is not as easily identifiable as that of a corporate’s. The reasons for this include, among others, (i) the existence of regulatory capital restrictions, (ii) an inter-dependence between the borrower and the lender and (iii) a dramatic change in the behaviour of the return on equity with respect to leverage when risks and credit spreads of both, lender and borrower, are accounted for. 1 – Introduction The impact of regulations on depository institutions [hereafter also referred to as lending institutions, lenders or banks] has turned capital structuring into an important area of concern and interest. Here as well, as in the case of corporate firms, the attention revolves around trying to identify the optimal capital structure, as this, presumably, enables the organisation to operate more efficiently. Unlike corporate firms, however, where the Modigliani-Miller [M&M] theorems have clear-cut consequences, applying capital structuring to banks is more subjective. The reason for this is that here capital structuring relies heavily on risk management and value creation, two factors that are tightly entwined, 1 March 2003. Paper can be found in http://rdcohen.50megs.com/DepInstabstract.htm. 2 I express these views as an individual, not as a representative of companies with which I am connected. 3 E-mail: [email protected] Phone: +44(0)207 986 4645. 4 A depository institution is a type of financial institution that, in its simplest form, borrows funds from deposits and/or other establishments and lends them to borrowers. In this process, revenue is created mainly from the margin between the rate of lending and the cost of borrowing.