Ludwig von Mises has this definition:
Banks borrow money in order to lend it; the difference between the rate of interest that is paid to them and the rate that they pay, less their working expenses, constitutes their profit on this kind of transaction. Banking is negotiation between granters of credit and grantees of credit. Only those who lend the money of others are bankers; those who merely lend their own capital are capitalists, but not bankers.
M&M applies to banks, too, but with a twist. Banks that get into financial trouble cause systemic damage, so even if M&M applies from the point of view of investors, society would prefer less debt and more equity. But bank investors want the opposite, because the “too big to fail” subsidy means that shareholders enjoy successful gambles while creditors are bailed out if things go wrong. This subsidy means that debt-laden banks are more valuable to investors. If M&M holds, the taxpayers’ loss is the bankers’ gain.
Bankers have tended to argue that equity is scarce and expensive and too much equity means that banks will make fewer loans at higher rates. M&M shows us that this argument is wrong in theory.
In practice, M&M roughly holds: as leverage falls, equity becomes substantially cheaper. Banks are tempted to take on more leverage not because debt is efficient but because debt is the route to an implicit government subsidy.
Banks should be obliged to use more equity funding – or in the misleading jargon of the industry, to “hold more capital”. But equity is not “held”. It’s perfectly good money, provided on flexible terms. It can be lent to businesses and homebuyers just like debt – and with far more resilient results.
I’m a huge fan of the M&M theory – but I’m not convinced that it applies to banking.
The thing is that M&M start their analysis under conditions of perfect markets and them derive their propositions. As exercises in logic they are correct. Then we usually go through the exercise of relaxing various assumptions and observe the changes in the results of the theorem. When you do this you find that transactions costs (costs of bankruptcy for example), agency costs, corporate taxation, asymmetric information etc. matter in the capital structure decision.
So too with banks. Under the M&M base case of perfect markets, banks would not exist at all. That is because banks would earn a zero-profit. The household sector would be able to borrow and lend in debt markets. So banks add value in a world where the M&M perfect market assumptions fail.
Now that doesn’t mean that banks are immune from poor business decisions. It also does suggest that the business of banking is particularly risky – that is why they earn those high profits. Excessive leverage will bring down a bank, just like any other business, if bad debts accumulate. Requiring a bank to hold more equity creates a buffer against poor lending decisions, it doesn’t actually prevent those poor decisions being made.
Bottom line is that pointing to the M&M theorem doesn’t add much value when thinking about banks. That theory predicts banks wouldn’t exist at all.