It is possible to go one step further and argue that higher bank capital ratios could potentially lower banks’ cost of capital. The size of the premium demanded by holders of equity is a long-standing puzzle in finance – the equity premium puzzle. 29 Robert Barro has suggested this puzzle can be explained by fears of extreme tail events. 30 And what historically has been the single biggest cause of those tail events? Banking crises. Boosting banks’ capital would lessen the incidence of crises. If this lowered the equity premium, as Barro suggests, the cost of capital in the economy could actually fall. The costs of prohibition Turning to the other side of the equation, what does existing evidence tell us about the costs to banks of restrictions, whether on the scale or scope of their activities? In Weitzman’s framework, how significant are the private costs of restrictions? Fortunately, there is a reasonably rich empirical literature on economies of scale and scope in banking. 26  Kay (op.cit.). 27  Kotlikoff (2010). 28  Modigliani and Miller (1958). See also Miles (2009). 29  Mehra and Prescott (1985). 30  Barro (2006). 10  BIS Review 40/2010  (a)  Economies of scale  On economies of scale, the literature tends either to look at the cross-sectional efficiency of banks of different sizes, or the time-series efficiency of banks either side of a merger. As it turns out, both roads reach the same destination.
As an example, in the FX market, concerns were raised about the integrity of FX rate benchmarks, particularly around incentives for potential market malpractice linked to the structure of trading around the benchmark fixings, such as the WM/Reuters 4pm London fix. The WM/Reuters fix is one of the long-standing and dominant benchmarks used in the market. It was structured in a way that created an incentive for dealers to “trade ahead” of clients at the fix and also an opportunity for them to influence exchange rates. The FSB’s FX benchmark working group produced recommendations that called for a change in methodology around the structure of the fix and changes in firms’ trading behavior at the fix. Guidance suggested that firms establish and enforce internal guidelines and procedures for collecting and executing fixing orders, such as separate processes for handling such orders. In addition, the group recommended that transactions conducted at to-be-determined levels be priced in a manner consistent with the risk borne in accepting such transactions through such methods as applying a bid-offer spread or a direct fee. The Global Preamble, published by the FXC in coordination with other FX committees, supported and reinforced the FSB’s FX benchmark recommendations. 15, 16 Since the release of the recommendations, a number of changes have been made. For example, there is a new structure for certain FX benchmark rates, including the WM/Reuters fix. Many dealers have changed how they provide FX benchmark execution, with a growing emphasis on the use of algorithmic execution and a more transparent pricing structure.