Countercyclical Bank Equity Issuance∗

It is well established that equity issuance for most non-financial firms is procyclical. This paper shows that, in contrast, equity issuance for banks is countercyclical across credit cycles after 1980, as is retained income. Thus, during credit booms, banks raise less equity, even though more equity might help banks better absorb shocks. This paper shows that government guarantees play a crucial role in driving banks’ countercyclical equity issuance. Countercyclical equity issuance arises in the U.S. during the bailouts of the 1980s, mostly in banks that equity markets perceive as having large implicit guarantees. Across types of firms, historical time periods, and countries, equity issuance is countercyclical when government guarantees are strong and procyclical when government guarantees are weak. Furthermore, bank equity issuance becomes more countercyclical in Eurozone countries that gain increased implicit guarantees upon adopting the Euro. These findings help explain why banks may resist raising equity during credit expansions, making financial distress more likely. ∗I am grateful to the following people for helpful discussion and comments: Yacine Aït-Sahalia, Nina Boyarchenko, Emre Ergungor, Maryam Farboodi, Valentin Haddad, Mitchell Hoffman, Harrison Hong, Jakub Kastl, Asani Sarkar, David Sraer, my fellow PhD students at Princeton, and seminar participants at the NY Fed. I would especially like to thank my advisor, Wei Xiong, my committee members, Markus Brunnermeier and Atif Mian, and also Tobias Adrian, Jonathan Brogaard, and Andrei Kirilenko, who have all played important roles in guiding my research. †Department of Economics and Bendheim Center for Finance, Princeton University. A central issue in banking finance concerns the optimal capital requirements of banks and whether bank equity is expensive from both a social and private point of view. It is often argued that higher capital requirements act to reduce banks’ risk-taking incentives and help banks withstand adverse shocks (see, for example, Admati et al., 2013a). As a result, higher capital requirements have been a key focus of recent financial reforms around the globe. To analyze optimal capital requirements of banks, it is important to understand why banks issue equity at some times and pay out equity at other times. This paper investigates the drivers of bank equity over the credit cycle. A robust fact for equity issuance by non-financial firms is that they issue more equity in good times, i.e. equity issuance is procyclical.1 This tendency makes sense because both investment opportunities for firms and their stock prices are high in good times, making equity issuance attractive for managers of non-financial companies. However, this paper demonstrates that the logic of this argument does not hold for banks: bank equity issuance is countercyclical.2 During credit booms, banks raise less equity, even though more equity might help banks better absorb shocks. Banks instead wait until after the downturn, when it is potentially more costly to raise equity and too late to mitigate a crisis. Why does the logic of procyclical equity issuance not hold for banks? The contribution of this paper is to demonstrate how bailout distortions and government guarantees may lead banks to choose countercyclical equity issuance. This paper shows that across types of firms, historical time periods, and countries, equity issuance is countercyclical when government guarantees are strong and procyclical when government guarantees are weak or absent. Importantly, countercyclical equity issuance arises in the U.S. during the bailouts of the 1980s and is driven by banks that equity markets perceive as having large implicit guarantees. In a difference-in-differences test, bank equity issuance becomes more strongly countercyclical 1See, for example, Marsh (1982), Pagano, Panetta, and Zingales (1998), Baker and Wurgler (2002), Hong, Wang, and Yu (2008), and Covas and Den Haan (2011). 2This paper analyzes cyclicality in terms of the credit cycle (i.e. aggregate lending by banks to households and non-financial firms), which is most relevant for banks. Similar patterns of equity issuance hold when defining cyclicality in terms of GDP or other variables.