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A. Appendix: Capital Accumulation Decomposition
We start from the identity for capital accumulation:
Here B is capital, BNI is newly issued capital, Income is a sum of net income and other income, and Div are dividend payments. Dividing both sides by Bt–1 and by risk weighted assets RWA, we get:
After log-linearization we obtain:
Where S, as a scaling factor, equals to:
B. Appendix: Stylized Facts
Banks in Eu emerging markets are highly profitable despite the real economy slowdown in the wake of the recent financial crisis, Figure B1. Banking sectors in these countries reached the highest average return on assets (RoA) in the EU. Only countries facing banking sector issues as Latvia, Slovenia, Hungary, and Lithuania either experienced losses or low RoA.
While the analyses presented in the paper are based on bank data aggregated by country, individual banks might differ in profitability, capital adequacy, and balance sheet structure. Figures B3, B4, and B5 show the distributions of CAR, RoE, and loans as a share of assets using bank data abstracting from countries. Boxplots are used to characterize the distribution of the data. At each point of time there is a box with a tick line. The box captures quartiles and the tick line is the median. Vertical lines coming out from the box depict lower and higher extreme values while points/dots are outliers. The data presented in figures suggest a relatively narrow distribution of CARs across banks with almost no downward outliers. Similarly, the share of loans as a share of total assets is relatively homogenous among banks. In contrast, RoE varies across banks from 0 to 20.
The banking sectors in HUN, LIT and SLO deleveraged measured by shares of loans and assets in GDP, Figure B6. In contrast, the shares continued to grow in remaining countries.
C. Appendix: The Leverage Arithmetic
The arithmetic of leverage is straightforward, but often goes under-appreciated. Two simple issues are worth mentioning to get a quantitative grasp of the change in banks’ leverage. First, even with a strong departure from the Modigliani-Miller Theorem (MMT), when the return on equity does not change, the weighted-average cost of capital does not increase in a dramatic manner. And second, the fact that banks are leveraged allows profitable banks to decrease their leverage quickly, should they choose so.
We would like to thank Ben Hunt for excellent comments and suggestions.
MMT and the conditions under which it holds are important for understanding why financial markets may deviate from this theorem. The key assumptions are efficient financial markets, and the absence of cost of bankruptcy and tax-code frictions, for instance, the preferential treatment of debt to equity. Much of the corporate finance after 1960s is about relaxation of the assumptions of the theorem and investigating the implications, see Stiglitz (1973).
According to the basic version of the theory, if the equity ratio is doubled, the Capital Asset Pricing Model (CAPM) “beta” of the firm should fall by half.
See Appendix for an example of the weighted-average cost of capital (WACC) calculation without MMT holding
Estonia is excluded from the sample because the data does not cover the period of interest.
Banks can use either standardized or Internal Rating Based system, which is subject to regulatory approval.
However, one might argue that a lower rate of lending can be beneficial if the economy faces excessive lending for non-productive use and capital is misallocated.
The value for existing shareholders is diluted if the new stock is issued for less than intrinsic, fair value of the corporation.
The issue of sovereign exposures and its regulation are discussed in European Systemic Risk Board (2015).
See Annex A for details.
Equity might be subject to deductions to be accounted as capital by the regulatory authority. In fact, the regulatory authority decides about what is going to be considered as capital.
Annex B reports shares of loans and assets on GDP for the set of countries and banks in our analysis. It shows that the share of assets and loans on GDP declined only in HUN, LIT, and SLO.
A bank levy has been introduced in Hungary since 2010.
These banking sectors also faced deepening of negative other net income.