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: The usual laws of corporate finance do not seem to apply to banks. Almost all big industrial companies—and decent analysts of them—are subject to a tight mesh of proven rules, backed up by decades of financial theory. Everyone agrees, for example, that accounting values are often flaky and that cashflow matters most when valuing a firm or trying to work out if it might go bust. The profitability of any activity, too, must be assessed before the magnifying effects of leverage are taken into account. In bank-land, however, anything goes. Accounting, not cash, is king. And most common yardsticks for measuring performance are all in some way distorted by leverage, not least return on equity (ROE).

The peculiarity of the banks is not some arcane matter. Regulators are furiously trying to find ways to prevent taxpayers picking up the tab for banking crises. The latest bill passing through Congress aims to hit the industry for the cost of bail-outs, for example. Their main weapon, however, is forcing banks to have bigger equity buffers. Bankers complain that equity is too expensive and will have a knock-on effect on the price of credit, damaging the economy. But this contradicts a cornerstone of corporate finance, set out by Franco Modigliani and Merton Miller in 1958, that a firm’s value is unaffected by its capital structure (at least in a perfectly efficient, tax-free world).

This theory says that although equity owners demand a higher return than creditors, their required rate of return on each unit falls as the amount of equity rises, since profits after interest become less volatile. The cost of debt falls too, since creditors have a bigger buffer beneath them. The firm’s blended cost of capital is unchanged, and is driven largely by the risk of the firm’s assets, not how they are paid for. At the extremes, it can be very low. A firm that owned only government bonds yielding 5% would have a cost of capital of just 5% even if entirely equity-financed.