Indeed it is possible that the attractiveness to those seeking funds of debt relative to equity is greater at higher interest rates. This is because interest payments are tax deductible whereas dividends are not. The scale of that subsidy to debt gets bigger as debt payments rise, which will happen as interest rates rise. A more formal version of this story goes like this: Suppose that nominal interest payments by issuers of debt, paying an interest rate r, are deductible against corporation tax (levied at rate tc) but that returns on equity paid by issuers have to come from post-tax income. Assume that all nominal returns received by holders of debt and equity are taxed at a common rate – a single rate that is charged on interest received, dividends and nominal capital gains. Because all receipts of income from financial claims are taxed at the same rate then the payments that need to be made by companies on debt and equity would, on average, need to be the same (because we ignore risk considerations). But companies can deduct interest payments against tax which means that the cost advantage of debt over equity to the company is measured by the nominal interest rate multiplied by the corporate tax rate – r x tc. This is increasing in the nominal interest rate. In this case, all else equal, the tax consideration is likely to lead to an increase in leverage when the nominal interest rate is higher.
But for any firm with less than average systematic risk and less than average leverage, the cost of equity would be lower; and at zero leverage, much lower, perhaps as low as say 6 percent. At that rate, even an all-equity bank with an expected return on assets of only 8 percent would not only be viable, but would presumably sell for a 1.3 premium over book value..... An essential message of the M & M Propositions as applied to banking, in sum is that you cannot hope to lever up a sow's ear into a silk purse. You may think you can during the good times; but you'll give it all back and more when the bad times roll around...... I can't  BIS Review 133/2010  11  who says “equity capital is very expensive to a bank” appears not to understand this. It might be fine for most people not to understand this – just as it is fine that most people do not understand what tensile strength materials need to have to be suitable to build a bridge with. But it is not fine if those that run banks, or regulate them, don’t understand it, any more than if engineers who design bridges don’t know about the strengths of building materials. In retrospect I believe a huge mistake was made in letting banks come to hold much less equity capital – relative to un-weighted assets – than was normal in earlier times.