Skip to Main Content
HBS Home
  • About
  • Academic Programs
  • Alumni
  • Faculty & Research
  • Baker Library
  • Giving
  • Harvard Business Review
  • Initiatives
  • News
  • Recruit
  • Map / Directions
Faculty & Research
  • Faculty
  • Research
  • Featured Topics
  • Academic Units
  • …→
  • Harvard Business School→
  • Faculty & Research→
Publications
Publications
  • 2013
  • Working Paper

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

By: Malcolm Baker and Jeffrey Wurgler
  • Format:Print
  • | Language:English
ShareBar

Abstract

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.

Keywords

Risk and Uncertainty; Cost of Capital; Capital Markets; Banks and Banking; Banking Industry; United States

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.
  • Read Now

About The Author

Malcolm P. Baker

Finance
→More Publications

More from the Authors

    • 2022
    • Annual Review of Financial Economics

    The Pricing and Ownership of U.S. Green Bonds

    By: Malcolm Baker, Daniel Bergstresser, George Serafeim and Jeffrey Wurgler
    • November 2022 (Revised January 2023)
    • Faculty Research

    Dicerna

    By: Malcolm Baker, Ishita Sen and Jonathan Wallen
    • 2022
    • Faculty Research

    How Do Investors Value ESG?

    By: Malcolm Baker, Mark Egan and Suproteem K. Sarkar
More from the Authors
  • The Pricing and Ownership of U.S. Green Bonds By: Malcolm Baker, Daniel Bergstresser, George Serafeim and Jeffrey Wurgler
  • Dicerna By: Malcolm Baker, Ishita Sen and Jonathan Wallen
  • How Do Investors Value ESG? By: Malcolm Baker, Mark Egan and Suproteem K. Sarkar
ǁ
Campus Map
Harvard Business School
Soldiers Field
Boston, MA 02163
→Map & Directions
→More Contact Information
  • Make a Gift
  • Site Map
  • Jobs
  • Harvard University
  • Trademarks
  • Policies
  • Accessibility
  • Digital Accessibility
Copyright © President & Fellows of Harvard College