Research Discussion Papers, Bank of Finland
Why is equity capital expensive for opaque banks?
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; (follow links to similar papers)
JEL-Codes: D82; G21; G35; (follow links to similar papers)
26 pages, January 26, 2012
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