(Published in WILMOTT MAGAZINE, Mar/Apr 2004, pp.38-49)
Ruben D. Cohen (e-mail)
We derive here a fundamental model for the capital structure of depository institutions. The derivation centres on the basic Modigliani-Miller [M&M] 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.