The point of departure for all modern research on capital structure is the Modigliani-Miller (M&M, 1958) proposition that in a frictionless world of full information and complete markets, a firm's capital structure can not affect its value. This proposition contrasts sharply with the intuitive notion that a firm with risk-free debt could borrow at an interest rate below the required return on equity, reducing its weighted average cost of financing and increasing its value by substituting debt for equity. But the powerful arbitrage arguments employed by M&M demonstrate that market prices will compensate for any leverage decision by the firm.
When leverage is higher, so are the risks to shareholders, increasing the costs of equity just enough so that the weighted average cost of financing remains constant. More general versions of M&M showed that the same result holds with risky debt the costs of both equity and risky debt respond so that the cost of financing is independent of leverage. The challenge to those who have come after M&M has been to identify credible departures from this frictionless world, analyze the implications of these departures for optimal capital structure, and test these implications against the empirical evidence.
This research is of particular relevance for financial institutions because these institutions lack any plausible rationale in the frictionless world of M&M. Most of the past research on financial institutions has begun with a set of assumed imperfections, such as taxes, costs of financial distress, transactions costs, asymmetric information, and especially regulation. Nonetheless, as Miller (1995) argues below, these imperfections may not be important enough to overturn the M&M Proposition. In contrast, most of the other papers in this special issue take the view (implicitly or explicitly) that the deviations from M&M's frictionless world are important, so that financial institutions may be able to enhance their market values by taking on an optimal amount of leverage.
The purpose of this introductory article, and indeed this entire issue, is to investigate the role of capital for financial institutions why it is important, how market-generated capital requirements differ from regulatory requirements, and the form that regulatory requirements should take. In the process, we examine the history of bank capital, discuss issues involved in implementing capital requirements, analyze problems in measuring capital, and investigate some of the unintended consequences of capital requirements. We also point out how the articles in the special issue contribute to this literature, as well as suggest topics for future research.
