Deck 13: Capital Structure

Question 1

Why is it incorrect to say that the lower ROE caused by higher bank capital will lead to lower shareholder value in banking, independently of any tax advantage of debt?

Answer 1

The tax deductibility of debt favors leverage, but this is so for all firms, not just banks.Apart from taxes, while it is true that higher capital will lead to a lower ROE, it will also lead to a lower expected return for the bank's shareholders, so that there is no effect on the NPV to the shareholders who are investing in the bank.

Question 2

The interest rate on deposits is less than the return on equity, so higher capital will decrease the value of the bank.Explain why this statement is false in the absence of taxes and any special rents/subsidies on deposits.

Answer 2

In the absence of taxes and special deposit rents, as the bank increases equity and reduces deposits, the yields on equity and deposits adjust to leave the value of the bank unaffected.See the discussion on pages 319-320 of the book, which relies on the Modigliani and Miller argument.

Question 3

The empirical evidence indicates that when banks suffer a loss of equity) capital, they lend:

A)less
B)more
C)about the same

Answer 3

A

Question 4

If the only benefit of debt financing for banks is the debt tax shield, how is an optimal capital structure determined by the bank?

Question 5

The following items are included in the regulatory definition of Tier-1 capital:

A)deposits
B)noncumulative, nonredeemable preferred stock
C)equity
D)subordinated debt

Question 6

Which of the following is true?

A)The M&M leverage indifference theorem applies to banks.
B)In the cross-section of banks, the value of the bank is increasing in its equity capital.
C)Capital is money that banks have to set aside, so it is unavailable for lending.
D)Increasing equity capital in banking will diminish shareholder value in banking by reducing the bank's return on equity ROE).

Question 7

Higher bank capital leads to stronger bank incentives to choose all correct answers):

A)screen their borrowers before lending to them.
B)monitor borrowers' repayment behavior after lending to them.
C)avoid excessive risk.
D)report higher income.
E)Use innovative covenants in loan contracts.

Question 8

Possible reasons why bankers appear to resist higher capital requirements are:

Question 9

The empirical evidence indicates that large banks create more liquidity when they have :

A)great managers
B)higher leverage
C)more capital

Question 10

Banks are so much more highly leveraged than non-financial firms because choose the best answer):

A)deposits are a factor of production in banking and deposits are considered debt.
B)deposit insurance provides banks with a safety net.
C)equity in banking is inherently more costly than in non-financial firms because bank investors want higher returns.
D)bankers love financial risk.

Question 11

Capital is money that banks have set aside and is therefore unavailable for lending, so an increase in bank capital requirements will reduce lending.Explain why this statement is false.

Question 12

In the aftermath of the financial crisis of 2007-09, it was asserted that one of the causes of the crisis was reckless risk taking by financial institutions.Risk-taking would have been lower if financial institutions had _______ capital before the crisis.Choose from:

A)less
B)about the same
C)more