Why is Equity Capital Expensive for Opaque Banks?

28 Pages Posted: 30 Jan 2012

Date Written: January 26, 2012

Abstract

Bank managers often claim that equity is expensive relative to debt, which contradicts the Modigliani-Miller irrelevance theorem. This paper combines dividend signalling theories and the Diamond-Dybvig bank run model. An opaque bank must signal its solvency by paying high and stable dividends in order to keep depositors tranquil. This signalling may require costly liquidations if the return on assets has been poor, but not paying the dividend might cause panic and trigger a run on the bank. The more equity has been issued, the more liquidations are needed during bad times to pay the expected dividend to each share.

Keywords: bank run, capital adequacy, signalling, dividends, irrelevance theorem

JEL Classification: G21, G35, D82

Suggested Citation

Kauko, Karlo, Why is Equity Capital Expensive for Opaque Banks? (January 26, 2012). Bank of Finland Research Discussion Paper No. 4/2012, Available at SSRN: https://ssrn.com/abstract=1993081 or http://dx.doi.org/10.2139/ssrn.1993081

Karlo Kauko (Contact Author)

Bank of Finland ( email )

P.O. Box 160
FIN-00101 Helsinki
Finland

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