Date of Award
Doctor of Philosophy (PhD)
The effect of financial leverage on valuation and shareholder wealth of the banking firm was examined both theoretically and empirically. It was assumed that market imperfections made possible the creation of a bank which would operate in capital, loan, and deposit markets. The valuation of equity shares was assumed to be described by Black's zero-beta version of the Capital Asset Pricing Model. Although the Black model is a perfect market model, it served as a framework within which imperfections could be introduced. A firm operating in a market without an intermediary was converted to a bank, charged with the responsibility of providing banking services, and allowed to issue demand deposits. The deposits were of the form of an initial inflow followed by outflows which equal inflows so that a constant level of deposit financing was maintained. A perpetuity model was assumed in the text although a single-period version was presented in an appendix. No taxes were assumed. Deposits were initially considered to be costless, riskless, non-interest bearing, and requiring no reserves. It was shown that the value of the bank and the wealth of its shareholders could be increased by using deposit leverage in lieu of equity. It was later verified that the presence of costly deposits, interest on deposits, and reserve requirements would reduce the benefits offered by deposit leverage but would not likely eliminate them. Required rate of return and cost of capital formulas were derived and reflected the advantage of deposits as a source of financing. Next, the bank was assumed to issue risk-free interest-bearing liabilities. It was shown that the use of this form of leverage was also advantageous to banks and their owners but less so than were deposits. An incentive for banks to maximize their use of such financing was shown to exist. Required rate of return and cost of capital formulas were presented and they also reflected the advantage of this source of financing. Empirical tests examined the effect of financial leverage on the systematic risk of banks. It was proven that if banks possess an advantage over non-banks in their financing operations, then that advantage would result in smaller increases in systematic risk as units of financial leverage are added. A sample of banks and two samples of non-banks were collected. Time series estimates of systematic risk were calculated and regressed on the debt/equity ratio. It was found that the model worked reasonably well although the presence of outlying observations and errors in the measurement of beta made it somewhat difficult to explain a large percentage of variance. A test was derived to measure the statistical differences between banks and non-banks in the effects of increases in financial leverage on systematic risk while taking into account differences in the underlying business risk of the samples. The results showed that an increase in leverage apparently does not produce as large of an increase in systematic risk for banks as it does for non-banks. The implication of this finding is that investors appear to recognize that for banks benefits are associated with debt financing which do not accrue to non-banks; thus, the well-known Modigliani and Miller theory which states that in the absence of taxes the amount of leverage is irrelevant does not apply to banks. The results have important implications for regulatory issues and in explaining bank financial management behavior.
Chance, Donald Malcolm, "Theory and Tests of the Effect of Financial Leverage on Valuation of the Banking Firm." (1980). LSU Historical Dissertations and Theses. 3517.