Contents

Preface ix

Acknowledgments xiii

1 Overview 1

Plan of the Study and Principal Findings 3

Framing Issues 12

Conclusion 19

2 A Survey of Literature on Optimal Capital 21

Requirements for Banks

Heuristic and Seawall Studies 22

Calibrated Optimization 28

Overview 38

Appendix 2A: Literature on Transient and Dynamic Stochastic 41

General Equilibrium (DSGE) Estimates

3 Testing the Modigliani-Miller Theorem of Capital 53

Structure Irrelevance for Banks

Is Banking Special? 55

Capital Assets Pricing Model Betas versus Direct Estimation 57

Arbitrage versus Optimization 59

Specifying the Tests 59

Data 60

Test Results 65

Implications for the Average Cost of Capital 66

Lower Borrowing Cost for Banks? 69

Conclusion 70

Appendix 3A: The Modigliani-Miller Model 71

Appendix 3B: Demonstrating Constant Average Cost of Capital 75

in Modigliani and Miller

Appendix 3C: Alternative Analyses of the Modigliani-Miller Offset 77

for Banks

Appendix 3D: Trends in Unconstrained Earnings Indicators of the 83 Cost of Equity Capital

Appendix 3E: Possible Endogeneity Bias 85

4 Benefits and Costs of Higher Capital Requirements 87

for Banks

Benefits of Higher Capital Requirements 88

Costs of Higher Capital Requirements 103

Optimal Capital Requirements 108

Results 110

Comparison with Other Estimates 114

Implications for Regulatory Capital 116

Further Considerations 118

Conclusion 121

Appendix 4A: An Evaluation of the Minneapolis Plan to End Too 123 Big to Fail

5 Total Loss-Absorbing Capacity for Large Banks 133

Survey of the Literature on Total Loss-Absorbing Capacity 134

Evidence on US Banks in the Great Recession 151

Share of the Largest Banks in the United States and Other 154

Countries

Bank Resolution and Crisis Management 157

Conclusion 162

Appendix 5A: Systemic Implications of Problems at a Major 165

European Bank

6 A Critical Evaluation of the “Too Much Finance” 177 Literature

Too Many Doctors? Too Many Telephones? Too Much R&D? 179 Demonstrating the Bias Toward Negative Quadratic Effects 181

Too Much “Too Much Finance” to Believe? 182

The Cournede-Denk Results 185

Reestimating the Impact of Private Credit 187

Conclusion 194

Appendix 6A: Spurious Negative Quadratic Influence in Estimation 197 Based on Related Linear Equations

Appendix 6B: Description of the Data 199

Appendix 6C: Reply to Arcand, Berkes, and Panizza 201

7 Conclusions and Policy Implications 205

Summary of Empirical Results 207

Implications for Basel Targets 209

Other Key Policy Issues 212

References 217

Index 229

Tables

2.1 Literature estimates of optimal ratio of capital to risk-weighted 39

assets

3.1 Impact of raising the capital-to-assets ratio from 10 to 25 percent 67

4.1 Estimates of output losses from banking crises in advanced 92

industrial countries, 1977-2015

4.2 BCBS synthesis of impact of capital on the probability of 100

systemic banking crises

4.3 Alternative parameter values for simulations 105

4.4 Other parameter and base values 105

4.5 Basel III and FSB capital requirements for G-SIBs 117

5.1 Indicators of relative impact of the Great Recession on largest 153

banks compared with medium-sized banks in the United States

5A.1 Ratio of share price to book value for global systemically 170

important banks (G-SIBs) in Europe and the United States,

October 26, 2016

6.1 Cournede and Denk estimates for three specifications of 185

regressions for per capita GDP growth

6.2 Cline estimates for four specifications of regressions for per 190

capita GDP growth

6.3 Growth results for low versus high financial depth 192

Figures

3.1 Net income relative to equity, earnings yield, and debt to equity 63 ratio, averages for the 54 largest US banks: Constrained data, 2002-13

3.2 Distribution of annual bank net incomes relative to assets, 54 64

largest US banks, 2002-13

3C.1 Bank lending rates in the United States and euro area, 2001-15 78

3D.1 Net income relative to equity and earnings yield averages for 83

the 54 largest US banks: Unconstrained data, 2002-13

3E.1 Relationship of unit cost of equity to debt-to-equity ratio 85

4.1 Losses from a banking crisis 90

4.2 Benefits of additional bank capital 102

4.3 Benefits and costs of additional bank capital 111

4.4 Frequency of estimates for optimal capital-to-assets ratio 112

4A.1 Probability of avoiding a banking crisis as a function of 125

capital/risk-weighted assets

4A.2 Probability of a banking crisis as a function of bank capital/ 127 risk-weighted assets, Basel Committee on Banking Supervision versus Minneapolis Plan

5.1 Change in net income relative to assets between 2006-07 and 152 2008-10 for 48 large US banks and natural logarithm of asset

size

5.2 Combined assets of 10 largest US banks as percent of GDP, 156

1995 and 2001-15

5.3 Assets of the five largest banks as percent of GDP in selected 157 economies, 2015

5A.1 Ratio of market price to book value for selected large US and 168 European banks, October 27, 2006 to October 26, 2016

6.1 Relationship between growth and financial depth or other 181

variable positively related to per capita income