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• Working Paper | 2013

  Do Strict Capital Requirements Raise the Cost of Capital? Banking Regulation and the Low Risk Anomaly

  Malcolm Baker and Jeffrey Wurgler

  Minimum capital requirements are a central tool of banking regulation. Setting them balances a number of factors, including any effects on the cost of capital and in turn the rates available to borrowers. Standard theory predicts that, in perfect and efficient capital markets, reducing banks' leverage reduces the risk and cost of equity but leaves the overall weighted average cost of capital unchanged. We test these two predictions using U.S. data. We confirm that the equity of better-capitalized banks has lower systematic risk (beta) and lower idiosyncratic risk. However, over the last 40 years, lower risk banks have higher stock returns on a risk-adjusted or even a raw basis, consistent with a stock market anomaly previously documented in other samples. The size of the low risk anomaly within banks suggests that the cost of capital effects of capital requirements may be considerable. Assuming competitive lending markets, banks' low asset betas implied an average risk premium of only 40 basis points above Treasury yields in our sample period; a calibration suggests that a ten percentage-point increase in Tier 1 capital to risk-weighted assets may have increased this to between 100 and 130 basis points per year. In summary, the low risk anomaly in the stock market produces a potentially significant cost of capital requirements.

  Citation:

  Baker, Malcolm, and Jeffrey Wurgler. "Do Strict Capital Requirements Raise the Cost of Capital? Banking Regulation and the Low Risk Anomaly." NBER Working Paper Series, No. 19018, May 2013.

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• Case | HBS Case Collection | 2012

  Restructuring at Nova Chemical Corporation (Abridged)

  Scott P. Mason and Malcolm Baker

  Citation:

  Mason, Scott P., and Malcolm Baker. "Restructuring at Nova Chemical Corporation (Abridged)." Harvard Business School Case 213-075, November 2012.

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• Teaching Note | HBS Case Collection | 2012 (Revised from original 2006 version)

  Wells Fargo Convertible Bonds (TN)

  Malcolm P. Baker

  Keywords: Financial Services Industry;

  Citation:

  Baker, Malcolm P. "Wells Fargo Convertible Bonds (TN)." Harvard Business School Teaching Note 207-032, October 2012. (Revised from original October 2006 version.)

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