Financial Times (Letters), 30th November 2010
Sir,
Data published by the Bank of England show that UK banks had, for many years, a return on equity which was similar to that on other industries, but which more recently has averaged about three times as much. The rise has accompanied a dramatic fall in the ratio of equity to total assets.
This can be readily explained in one of two ways. The first is that the rise in the return has reflected the increased risk to investors that the higher leverage involves and that the high return reflects the higher returned required to offset this risk. If this is so, then David Miles (“Banks fail to convince crying foul over Basel reforms”, November 24) is correct to argue that higher equity ratios will make little difference to bank lending margins, as the cost of equity will fall as equity ratios rise.
The alternative explanation is that returns in banking are high due to a lack of competition, which allows large scale “rent extraction” by banks. If this is the case, the requirement for higher bank equity ratios will have no impact on bank lending margins unless they are not yet already exploiting to the full extent their capacity for rent extraction.
Whichever explanation is preferred, higher equity ratios for banks are unlikely to have much impact on the cost of borrowing from banks.