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.