Do Increased Capital Requirements Lead to Higher Interest Margins? -A Study in the Swedish Banking Sector

Abstract

This paper examines the impacts of the capital ratios stipulated in Basel III on banks’ interest margins. The Basel III rules were established as a response to the financial crisis in 2007-2009 when it became obvious that the previously existing rules were unable to cope with the growing complexity of the financial markets. The four largest banks in Sweden are analyzed: Nordea, Svenska Handelsbanken, SEB and Swedbank. The central theoretical backbone is the Modigliani Miller theorem with the presence of corporate taxes, which states that when a firm’s equity to total assets increases, the results are higher funding costs. The results of the quantitative study show that capital ratios calculated using risk-weights do not seem to have a significant effect on interest margins for the four largest banks in Sweden. However, the Equity Ratio calculated on total assets, using no risk-weights, has a positive effect on interest margins in the Swedish banking market. This empirically provides support for the specialized Modigliani Miller theorem with corporate taxes.