The FSA has published a speech given by Thomas Huertas (Director, Banking Sector, and Vice Chairman, the FSA) which is entitled Improving bank capital structures.

At the beginning of his speech Huertas briefly discusses the articles produced by Modigliani and Miller (1958, 1961) which demonstrated that the value of a firm is invariant with respect to its financing decisions, such as the degree of leverage and dividend policy. This result is based on two assumptions:

  • The value of the firm is not dependent on the liabilities that the firm issues.
  • The market is perfect.

However, Huertas argues that neither of the above assumptions is true for banking and that:

  • The value of a bank is not solely determined by the value of its assets.
  • The market is not perfect. In particular, bankruptcy costs for banks are particularly large.

Huertas states that banks are different and that their failure would potentially give rise to much larger social costs. Given this banks are accorded a safety net (deposit guarantees, lender of last resort, open bank equity assistance) and this weakens market discipline, especially in the case of banks that are regarded as ‘too big to fail’.

Huertas then looks at some of the policy measures that have been taken to reduce the social impact of bank failures and improvements to market discipline. Huertas discusses:

  • Special bankruptcy code for banks.
  • Strengthening deposit guarantee schemes.
  • Strengthening infrastructures.
  • Improving the quality of capital.
  • Introducing recovery and resolution plans (living wills).

In the final part of his speech Huertas discusses the overall calibration of the capital regime. He states that society and to some extent banks face a choice between two alternatives:

  • High impact/high cost, where banks really are too big to fail and all capital has to take the form of equity
  • Lower impact/lower cost, where living wills and measures to strengthen infrastructures reduce the impact on society of a bank’s failing, and a significant proportion of capital can take the form of debt (contingent capital).

Huertas concludes that considerable time and effort should be given to explore whether the second option can work. That is a system where markets as well as supervisors discipline banks and where banks can continue to play the major role in providing the financial intermediation that is essential for economic growth.

View Improving bank capital structures, 18 January 2010