An answer to Martin Wolf’s question.

He wrote an article in the Financial Times some time ago entitled “Seven Ways to Clean up our Banking Cess-pit”. See here or here. He advocated a HUGE increase in bank capital ratios: up from the present 3-6% to about 25%: quite right.

However, he argued AGAINST raising that still further to 100%, which would amount to full reserve banking. And his reason was:

“I accept that leverage of 33 to one, as now officially proposed is frighteningly high. But I cannot see why the right answer should be no leverage at all. An intermediary that can never fail is surely also far too safe.”

The answer to that is: “it all depends on the cost of attaining total and complete safety”. If the costs are zero, then total and complete safety makes sense.

And in the case of banks, the costs of total and complete safety ARE ZERO, and for reasons spelled out by Messers Modigliani and Miller. As M&M correctly pointed out, the costs of funding a given bank which engages in a given set of activities and hence takes given risks is a GIVEN. Thus the charge made by those covering the risk is a given. Thus if the charge is spread over a larger number of “risk carriers” i.e. shareholders rather than a smaller number, there’ll be no change in the TOTAL CHARGE made for covering the risk. Thus moving from 25% to 100% involves no costs.

The M&M theory HAS BEEN criticised, but I’m not impressed by the criticisms. About the most popular criticism seems to be that the tax treatment of bank capital and bank debt is different, thus, so the argument goes, M&M does not work out in the real world in the same way as it does in theory. For example that is the first criticism listed in a paper by three Bank of England authors entitled “Optimal Bank Capital” (p.9).

However, that “tax” criticism is feeble. Reason is that tax is an entirely ARTIFICIAL imposition. Thus for the purposes of gauging REAL costs and benefits, tax should be ignored.

The second criticism of M&M in the latter paper is that the charge made for deposit insurance may not reflect the risk.  Well the answer to that is much the same as the answer to the above “tax” criticism: for the purposes of gauging REAL costs and benefits, any “incorrect” or artificial charges should be ignored. That is, in such cost / benefit calculations or arguments, correct or accurate charges should be assumed, even if those are not the charges that obtain in the real world.

Game set and match to M&M.