Impact of higher capital requirements on bank funding costs: Australian evidence

In response to the experience of the 2007-2009 global financial crisis, capital requirements have been raised for banks across many jurisdictions. With the highly concentrated nature of the Australian banking sector and the implementation of an imputation tax system, an ideal natural experimental environment is available to empirically examine the impact of higher capital requirements on bank funding costs in a small open economy that is heavily reliant on banks for funding economic growth. This study examines the extent to which the risk premium on bank equity decreases as more equity is added to a bank's capital structure, as predicted by the Modigliani-Miller (M-M) theorem. The results suggest that the M-M offset effct on equity risk is realised to around 25% to 30% of the extent it would be if the M-M theorem held exactly. A reduction in the equity risk premium helps cushion the impact of higher equity capital requirements on bank funding costs. Therefore, a doubling in bank market capital from 10% to 20% of total assets would have a relatively mild impact on bank funding costs in the long-run, ranging from 18 basis points (bps) to 55 bps for small banks and from 36 bps to 94 bps for large banks. The cost to banks of maintaining higher risk-based regulatory capital ratios is further reduced when the risk weightings on bank assets are less than one and the bank equity trades at market-to-book ratios greater than one.