I wasn’t trying to sneak in an assumption of bimodality, I just wanted to go through the math for two relevant examples: 10% equity (where banks currently are) and 50% (where Cochrane wants them).
But aren’t you doing that when you say “Perhaps shareholders will take a slightly lower return in exchange for a safer investment, but they wouldn’t take one-third.”? If the capital requirement was 50%, then sure the return for shareholders would be much lower, but so would their risk since the overall risk would be distributed over a much larger pool of equity. Why wouldn’t there be lots of shareholders willing to take that deal if preferences for risk/return wasn’t bimodally distributed?
Well, as a matter of fact it doesn’t seem like they do—they want 8%-15%. You could start a bank that promises to stay at e.g. 30% equity, but the market seems to indicate that you’ll have a hard time finding investors. Banks work hard to differentiate themselves since they ultimately offer very similar products, and I don’t know of any large bank that successfully differentiates by having high equity ratios.
Especially as in recent years investor preferences for lower risk, low beta, low vol, higher yield stocks (like utilities and staples) has been well documented as strong.
One related fact is that (at least some of the banks) feel like they haven’t gotten credit for the risk reductions they have done. Given their lower leverage now, they feel like they should have higher multiples, whereas actually their relative multiples have compressed vs the market vs pre-crisis. Of course, this may be because their risk was under-estimated pre-crisis, so their relative multiple was too high.
But aren’t you doing that when you say “Perhaps shareholders will take a slightly lower return in exchange for a safer investment, but they wouldn’t take one-third.”? If the capital requirement was 50%, then sure the return for shareholders would be much lower, but so would their risk since the overall risk would be distributed over a much larger pool of equity. Why wouldn’t there be lots of shareholders willing to take that deal if preferences for risk/return wasn’t bimodally distributed?
Well, as a matter of fact it doesn’t seem like they do—they want 8%-15%. You could start a bank that promises to stay at e.g. 30% equity, but the market seems to indicate that you’ll have a hard time finding investors. Banks work hard to differentiate themselves since they ultimately offer very similar products, and I don’t know of any large bank that successfully differentiates by having high equity ratios.
Especially as in recent years investor preferences for lower risk, low beta, low vol, higher yield stocks (like utilities and staples) has been well documented as strong.
One related fact is that (at least some of the banks) feel like they haven’t gotten credit for the risk reductions they have done. Given their lower leverage now, they feel like they should have higher multiples, whereas actually their relative multiples have compressed vs the market vs pre-crisis. Of course, this may be because their risk was under-estimated pre-crisis, so their relative multiple was too high.