Prof. Dr. M. Shamsul Haque.*
The theory proposed by M-M in mid-sixties was a major development in the field of finance. They also got Nobel Prize in economics as it was repeatedly tested by scholars all over the world. Recently with the financial crisis raking havoc to major economies the theory is being revisited by many. FE carried a discussion on the topic on Dec 20 from FT syndicate service. As a researcher in finance it drew my attention and as I have written on the topic on many occasions I am presenting my thoughts on the topic. The issue has been taken up now in connection with so called capital adequacy ratio for banks under Basle 11. Jon Key a renowned commentator on finance wrote the piece in FT and I am taking some of the points raised in that paper as it is also relevant for the banking sector in Bangladesh. In the context of the financial crisis many including this scribe argued for increased equity capital for banks to cushion for higher default risk. The banking community argued that equity capital costs more than debt as it is riskier. “But if a business- a bank for example – increases its equity relative to its debt that reduces the riskiness of equity because operational risks are spread over a wider base. Reduced leverage also reduces the riskiness of debt –that there is a larger cushion of equity to protect the creditors.” Wrote John Kay. So why shout more equity will raise cost of capital for a bank? For that reason higher cost of equity will be off set by the lower rates on both equity and debt. That is the ingenuity of M-M proposition. That is why in their model the cost of capital to a business is unaffected by the ratio of equity to debt.
It is also known that riskiness of a business rests on the variability of its operating earnings and financial engineering can influence only the manner in which risks are shared among different investors, John Key wrote. In other words investors simply share the same pie whose size is determined by operating profits. The paper also mentioned one of the letter writers in the FT, who noted that “a bank of England study showed little relationship between banks’ capital ratios and funding costs. The implication is that even if the Basle Committees think capital adequacy a good measure of a bank’s soundness, the market does not”. – A proof of M-M again. The Basle Committee is proposing now to treat banks as utilities and fix their ROE at 15%. That has raised another set of debates. First is, if any Committee can really monitor and calibrate such a measure and a uniform ROE for all kinds of institutions globally, and two is the impact of such a high ROE for banks on the real economy. Take the case of Bangladesh with commercial banks, specialized banks, leasing companies, merchant banks etc. A WB study on the banking sector on South Asia has reported very high ROE for the year 2006, 33.36% , almost 98% increase from the ratio of 17.12%, and ROA doubled over the six year period to reach 1,66% at the end of 2006. No doubt the booming banking sector realized much higher ROE in recent years for which their market value was pushed up beyond any fundamental. Returns in Pakistan were still higher and those in India were much lower.
Anyway the more substantive issue was noted by John Kay by quoting from a report of the Bank of International settlements (BIS) on the potential impact such ROE fixing for banks. BIS has “estimated the costs of the new Basel obligations. In BIS’s word- a rate of return on equity of 15%. If banks do indeed earn 15% on a much expanded capital base, then they will impose a tax on the non-financial economy, which is an obstacle to growth and innovation”. John Kay concluded that such higher costs on the real economy may not contribute much to financial stability. If we assume that is even true partially ( 15%vs 35%) we can imagine how much adverse impact the banking sector has been imposing on the growth of the real economy in Bangladesh. Banks in Bangladesh are oligopoly and oligopoly entails excessive profits is well stabled in the economic literature. Bangladesh Bank should examine the matter with extreme seriousness. Fixing ceiling on ROE may be a good way to reduce real economy. Allowing more banks willing to accept such a ceiling should a strategy to stop banks from excessive earning spree as it has happened in 2010 and led to crash in the stock markets.
* Prof. Dr.M.Shamsul Haque, Vice Chancellor Northern University Bangladesh .
