Daily Archives: April 13, 2012

Part II -The cost of equity

Read Part I: Thoughts on Peter Sands

Now, let me turn to Peter Sands’ second and most important point. He condemns the notion that the cost of equity has fallen or might fall, as a result of lower leverage.

The idea that the correct target for banks is the risk-unadjusted return on equity is as close to a religion as one can find in banking. It is always buttressed by the view, also advanced by Mr Sands, that these returns on equity somehow do not depend on risk.

Yet that is utterly at odds with everything bankers do in their daily lives.

Suppose that Mr Sands’ subordinates suggest that his bank lends $100m to a certain company. He would surely want to know how indebted the company was and where the bank’s lending would be in the order of seniority. If his colleagues responded by telling him that none of this mattered, Mr Sands would surely sack them. The riskiness of lending to a company depends, in part, on the level, cost and structure of its debt.

Now consider the position of an investor in common equity. Such an investor is, by definition, junior to all other claimants. Equity investors must be interested, therefore, in how leveraged the company is: higher leverage does, other things being equal, raise their expected returns and the expected volatility of returns. This is finance 101.

Every banker knows it.