Modigliani Miller Doesn't Hold in a 'Bailinable' World: A New Capital Structure to Reduce the Banks' Funding Cost
To protect retail investors from the bail in rule, we propose that banks should issue subordinated "contractual bail in instruments" as defined in the BRRD, for an amount (together with Tier1 capital) at least equal to 8% of their liabilities. We support our argument by means of a theoretical model, where retail investors are uncertainty averse, due to their lack of information about the new "bailinable" regime. To the contrary, institutional investors are better informed. Within this framework, a bank is able to reduce the cost of debt by splitting it into a junior and a senior tranche, sold to institutional and retail investors respectively. This result is a deviation from the Modigliani Miller theorem. We also provide some estimates of the amounts of contractual bail in instruments that European banks should issue in order to reach the 8% target level. Such amounts are considerable, implying that the solution proposed here should be implemented gradually over a transition period.