Banks are Different

"The usual laws of corporate finance do not seem to apply to banks. ... The profitability of any activity, too, must be assessed before the magnifying effects of leverage are taken into account. In bank-land, however, anything goes. Accounting, not cash, is king. And most common yardsticks, for measuring performance are all in some way distorted by leverage, not least return on equity (ROE). ... Bankers complain that equity is too expensive and it will have a knock-on effect on the price of credit, damaging the economy. But this contradicts a cornerstone of corporate finance, set out by Franco Modigliani and Merton Miller in 1958, that a firm's value is unaffected by its capital structure (at least in a partially efficient tax-free world). ... The firm's blended cost of capital is unchanged, and is driven largely by the risk of the firms assets, not how they are paid for. ... Why, then, are banks different? ... A century ago, when banks could fail, they carried equity buffers of about twice today's levels in order to reassure customers. ... It is not just guarantees which make deposits special. They are also priced off central banks' short-term interest rates. ... America's mega-banks typically paid a blended annual interest rate on borrowings and deposits of 1-2% in the second quarter. Equity cannot compete with that. Banks' privilieges mean the rules on cost of capital break down. ... Once society underwrites banks, the choice is between big equity buffers that push up the price of credit but make things safer, or smaller buffers and periodic bail-outs. Which is best? Some of the predictions made by banks about the impact of more equity on the cost of credit are silly", my emphasis, Economist, 29 October 2009, link: http://www.economist.com/businessfinance/economicsfocus/PrinterFriendly.cfm?story_id=14744822.

No one who graduated one of our "better" MBA schools in the last 35 years should be taken in by bank accounting nonsense. I have often said bankers are amongst our two stupidest groups of businessmen. They can't understand cost of capital (COC). Or perhaps they do and what appears to be stupidity is just bank special pleading. We have COC in leasing, my 7 November 2009 post: http://skepticaltexascpa.blogspot.com/2009/11/they-never-learn.html. Big 87654 firm partners seem not to understand it, nor PhD "experts" or PCAOB people. For a banker who knows his business, see my 21 June 2009 post: http://skepticaltexascpa.blogspot.com/2009/06/old-school-banker.html.