It would appear so if the Reserve Bank of India's draft guidelines on the entry of new private banks is any indication. Indeed, an interesting conceptual issue thrown up by the draft guidelines is about the validity of that well-known capital structure theorem in the realm of banking and, more generally, financial intermediation.

For, if an RBI working group's recommendations on higher capital requirements for non-bank finance companies is any indication, Modigliani-Miller (MM) would seem to apply generally in the borrowing/lending business and not only in banking.

To be sure, stringent higher capital requirements are now almost taken as a non-negotiable as the global financial regulatory architecture undergoes a radical transformation in the wake of the crisis of 2007-08.

We have come through a period where too many institutions had too little capital to back their vast balance-sheets of complex assets — prime examples being Fannie Mae and Freddie Mac in the US apart, of course, from the investment banks in the private sector.

Their ultra thin capital bases quickly exposed external creditors to the destruction on the asset side of their balance-sheets resulting in the inevitable bailouts and a reiteration of the TBTF (too big to fail) situation.

Viewed in that backdrop, the RBI's concerns and hence its stern approach to the issue of capital requirements can be well understood.

The key questions though are: Whether such a stringent approach is compatible with other developmental objectives.

For instance, financial inclusion is going to be a touchstone against which the RBI is going to even consider the prospective applications for a banking licence.

One wonders if the rigorous approach to capital requirements can help progress towards that objective, since such an approach seems quite capable of raising costs all around for a new bank.

Theorem explained

The famous MM capital structure theorem says that, subject to a number of assumptions, the form of financing a firm employs does not affect the total value of its assets.

A key implication of this theorem is that there should be a link between the cost of debt for any institution and the amount of equity it has. If we consider that extra equity makes the debt safer, then the cost of debt should become cheaper. That is, the apparent higher costs in raising extra equity may be potentially offset by cheaper debt costs leaving the firm's overall weighted average cost of finance broadly unchanged.

Now, applying this principle in banking capital structure, can we say that the higher capital adequacy ratio or the lower leverage ratio which the RBI stipulates can directly bring down the costs of debt for a bank or generally for any lending institution?

For, only if debt costs become cheaper can the bank produce a certain level of post-tax profits (without increasing its lending rates) designed to attain some targeted return on equity.

Mind you, an attractive target return on equity and achieving that is critical since the draft banking guidelines say that the new bank has to be listed within two years of its licensing.

If debt costs are not lowered as a sequel to the higher capital levels, then the bank has to perforce increase its lending rates to attain a certain targeted level of profits in order to generate its desired return on equity.

The risk here, of course, is of the bank pricing itself out of the lending business if it were to post lending rates substantially out of line with the market. The risk is also of the bank infusing a higher level of credit risk into its balance-sheet.

Capital adequacy

The guidelines say that the new banks have to maintain a minimum capital adequacy ratio of 12 per cent or such higher ratio as the RBI may prescribe for a minimum period of three years from the commencement of its operations. The capital ratio for banks currently in business is 9 per cent.

We can formulate the above conditions as follows:

Return on equity = (Post-tax profits / Total assets) x (Total assets / Equity)

As the equity capital level rises, the bank has to generate a higher level of profits in order to attain a given level of return on equity.

Some basic calculations can show that if capital requirements are at 12 per cent as against 9 per cent, post-tax profits have to be equally higher — that is, by some one-third for the bank to post its targeted return on equity.

As indicated above, if debt costs decline commensurately, then the bank can generate the required level of profits without increasing lending rates to satisfy its equity returns target.

But can and will debt costs decline — particularly in the Indian situation where Indian banks' recourse to the broader capital markets as a funding source is almost minuscule relative to the scale of their operations.

Retail deposits are the predominant source of debt funding for Indian banks and it is a moot point if they are at all sensitive to the level of capital the bank holds.

Debt costs, higher lending rates

The monetary authority's policy rates, money market rates, the intensity of competition, balance-sheet composition and liquidity considerations — these are among the myriad factors impacting the rates which a bank posts on its deposit offerings. Where does the capital structure come into this picture at all?

If debt costs remain insensitive to the capital structure, a new bank may perforce have to contemplate higher lending rates.

It is in this backdrop that one wonders if the stipulations on higher capital are compatible with the broader economic objectives outlined in the guidelines.

From the financial inclusion perspective, what can such higher lending rates mean? Would it make that objective more difficult to be attained? To be sure, higher rates per se need not be a show-stopper for it has been well established that cost and availability of credit both matter equally for those ignored by the mainstream financial system.

Still, one lending institution's rates cannot be out of kilt with that generally prevailing in the market unless we are talking about different types of financial intermediaries such as banks, non-banks, investment and savings institutions and so on.

(The author is Vice-President (Economic Research), Shriram Group Companies, Chennai. The views are personal.)

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