The interest rate on deposits is less than the return on equity, so higher capital will decrease the value of the bank.Explain why this statement is false in the absence of taxes and any special rents/subsidies on deposits.

Question

Quizplus · Accepted Answer

The Answer is In the absence of taxes and special deposit rents, as the bank increases equity and reduces deposits, the yields on equity and deposits adjust to leave the value of the bank unaffected.See the discussion on pages 319-320 of the book, which relies on the Modigliani and Miller argument.

The Interest Rate on Deposits Is Less Than the Return