Academic Leap

I have been reading some very good academic papers on whether equity capital is really more expensive than debt financing, and thus whether we should be really concerned by banks being demanded to alter their equity-debt mix by reducing leverage. Some financiers say that ehanced equity requirements will sink the economy, as the cost and availabity of credit would become less socially friendly.

Bollocks, say the professors (from top unis). The myth that equity is more expensive is just that, a myth. No bank should have to push loan costs up or reduce lending as a result of tougher capital regulation. And Basel III, publicly portrayed as the proper medicine to the disease of excessive leverage, is not even enough.

I have been surprised by the profs´candor and their brave contrarianism. In one fell swoop, they manage to go at both the regulators and the bankers. But I wonder if they realize the implications that their arguments have in terms of the use of models in finance. Naturally, for the past fifteen years capital requirements have been based on models. These models, not surprisingly, have enabled unlimited leverage and have allowed banks to trot along equity-free. So an argument for equity should automatically imply an argument against said models. And an argument against said models should imply at the very least a very serious rethinking of the overall role of models in finance. Among other things, because the models used for regulatory capital include some of the ideologies and tools held most sacrosanctly by theoreticians. If those models fail (because they inexcusably sanction too little equity) then those ideologies and tools failed. If those failed, what does that say about the discipline of finance theory?

Shuldn´t these profs take the leap from "more equity is good net net, leverage is bad net net" into "theoretical finance has failed us much too much, let´s rethink how we teach and what we publish"? I understand that that may be a contrarian bridge too far (given that the fellow in the university office next door may have devoted an entire career to those failed models, for instance), but it would nonetheless be a very positive development not just in the aid for truth but also from a social point of view (it is obvious to these academics that bank leverage is a horrible horrible thing that causes untold mayhem, so fighting tools that abet the monster should be a good deed, right?).

I have humbly made that leap several times (read chapter 5 in my Lecturing Birds On Flying, or any of my FT articles on the subject, or my recent Yale Economic Review piece). Wouldn´t it be nice if uber-prestigious tenured ivy-leaguers would too choose to leap forward?