Sunday, 7 September 2014

Miller & Modigliani’s critics are clueless.

Under full reserve banking, entities that lend to mortgagors and businesses must be funded just by shareholders. Now that might see a bit extreme: that is, why not just go for the sort of capital ratio advocated by Martin Wolf and Anat Admati namely about 25% rather than the above 100%? 25% is way above the ratio that existed prior to the crunch and it’s way above the sort of ratio advocated by Basel, Dodd-Frank, etc. Doesn’t 25% reduce the chance of a bank / lending entity failing in any given year to about one in a hundred?
Well not in the case of small banks in the US. That is, it’s far from unheard of for the assets of those banks to fall to below 75% of their liabilities. So in those cases, a 25% capital ratio does not save the day. But let’s concentrate on large banks, and let’s assume that a 25% capital ratio reduces the chance of failure in any given year to about one in a hundred.
That raises the question as to whether it is worth going for a 100% capital ratio so as to reduce the chance of failure to about one in a thousand. Well the answer to that all depends on the COSTS of attaining that additional safety: if the costs are negligible, then why not go for the extra safety?
Now a popular argument against raised capital ratios is that bank shareholders demand a higher return than depositors because of the risk run by shareholders, ergo, so the argument goes, the higher the proportion of bank funding that comes from shareholders, the higher the cost of funding the bank, an argument that banks know perfectly well to be a load of nonsense. And the argument is nonsense for reasons set out by Modigliani and Miller (MM).
The MM theory as applied to banks runs essentially as follows. The risks involved in funding a given bank are a GIVEN. Thus if the proportion of funding that comes from shareholders is raised, the total cost of covering the latter risk remains unaltered: i.e. all that happens is that the risk per share or per shareholder declines. Thus raising the proportion of bank funding that comes from shareholders has no effect on the cost of funding the bank.
Moreover, numerous non-bank corporations are funded mainly by equity rather than by debt (short or long term). If funding mainly via equity really was expensive, those corporations would have cottoned onto the fact by now.
The MM theory HAS BEEN criticised however. These criticisms are actually a motley collection of half-baked nonsense. But anyway, let’s run through them.
Incidentally, raised capital ratios WILL RAISE the cost of funding banks in that those raised ratios necessarily reduce the extent of taxpayer funded bank subsidies. Put another way, there is a big reduction in the likelihood of taxpayer funded bank bailouts being needed when capital ratios are raised from about 3% to about 25%. While there is a much smaller reduction in the chance of bailouts being needed when ratios rise from 25% to 100%.
But there is nothing wrong with disposing of bank subsidies. Anyway, let’s get stuck into the half-baked criticisms that have been made of MM.
1. Tax. 
About the most popular criticism of MM has to do with the different tax treatment of bank capital and bank debt. At least that tax point is the first criticism cited by Douglas Elliot, David Miles, and Vickers, and it is only one of two criticisms cited by Lev Ratnovski and the ONLY criticism cited by Anil Kashyap. Urs Birchler also cites the tax point.
This tax criticism of MM is simply that if the tax treatment of bank capital and bank debt is different, then MM does not work out in the real world in the same way as it does in theory.
The very simple answer to that is that tax is an entirely ARTIFICIAL imposition. Thus for the purposes of gauging REAL costs and benefits, tax should be ignored. If a big tax was imposed on apples, and for no good reason, that would not mean that the REAL COST of producing apples had risen.
A fifteen year old of average intelligence ought to be able to work that out.
It is INCREDIBLE that the above six so called “authorities” who cite the tax criticism of MM have apparently not tumbled to the latter simple flaw in the tax criticism, but that seems to be the case. And if the latter tax criticism is the best that the critics of MM can do, then rest assured that the other criticisms (dealt with below) are near hopeless.

2. Different returns on capital and debt.
Ratnovski’s only other criticism of MM, which he does not present with what seems a lot of confidence, is that assuming the return on bank capital is 15% and the return on bank debt is 5%, then the more capital there is, the higher the cost of funding the bank.
Answer. Well of course, but it’s PRECISELY the latter sort of 15%/5% assumption that MM demolishes. Ratnovski’s point there is a bit like saying “if the Earth was flat we would not have weather satellites”. The answer is  . . . wait for it . . . that the Earth is actually round, so we do have weather satellites.

3. Incorrectly priced deposit insurance.
The second criticism of MM made by Miles (also the second criticism made by Elliot is that the charge made for deposit insurance may not reflect the risk, in which case MM would not work out in the real world the way it does in theory. 
Answer. The flaw in that argument is much the same as the flaw in 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.

4. Asymmetric information.
Elliot’s third criticism (also made by Birchler) is that new share issues have to be offered at a discount because those buying shares do not have perfect information about what a bank does.
Answer. Exactly the same applies to bonds issued by a bank and to deposits. That is, depositors and bond holders do not trust banks 100%, thus depositors and bond holders “lend” less to banks, and charge a higher rate of interest for doing so than if they had perfect information about the bank.

5. Regulators and banks do not agree on MM.
Birchler seems to think that the fact that banks and regulators do not agree on the relevance of MM is a weakness in MM. As he puts it in reference to MM, “Bankers and regulators thus fail to agree on the relevance of even the validity of a half-century old theorem.” (The “theorem” is of course MM).
Answer. This might be news for Birchler, but cops and robbers often disagree! In fact it is not unknown for them to employ extreme violence against each other. And if there is any doubt that banks are robbers, remember that they have been fined around $100bn in the US recently. Yes that’s billion, not million.

6. Bank shareholders want leverage.
Another feeble point made by Birchler is that bank shareholders want leverage. As he puts it, “Firstly, once a bank is already leveraged, shareholders are tempted to push leverage further leverage”.
Answer. Well of course they will. Pickpockets, if they were as brazen as bankers, would be “tempted to push for” the right to pick pockets.

7. State guaranteed deposits.
Birchler’s next criticism of MM is that banks do not need more capital because they can fund themselves from taxpayer backed deposits. As he puts it “..banks can raise insured deposits (or liabilities with implicit state guarantee).”
Answer. Well of course, but taxpayer backed deposits are a subsidy of banking! Hopefully readers will forgive me if I ignore the rest of Birchler’s article. It is clearly a waste of ink and paper.

8. Banks will increase risks.
Elliot’s fourth criticism is that higher capital ratios, improve bank safety, which may induce banks to take bigger risks.
Answer. The WHOLE POINT of raising capital ratios is to prevent banks offloading risk onto taxpayers. And if banks find they cannot unload that risk, i.e. have to carry the risk themselves, they are almost bound to become more cautious or responsible, rather than (as suggested by Elliot) take bigger risks.
If the state guaranteed to replace my car if I write it off in an accident, that is an inducement to irresponsibility on my part. If I then have to insure it myself, assuming there is a significant no claims bonus, then I will drive more responsibly.
But if by any chance higher capital ratios DID RESULT in increased risks, why should we care? As long as the risk is taken by shareholders rather than taxpayers, then that is free markets working in the way they should. Oil companies take big risks when drilling for new oil deposits: sometimes there is no oil there. That is how capitalism and free markets work.
The beauty of a bank that is funded just by shareholders is that if risks do not pay off, it cannot go insolvent, which disposes of systemic risks. As George Selgin put it in his book on banking, Selgin (1988), “For a balance sheet without debt liabilities, insolvency is ruled out…”.

9. The transition to full reserve.
Elliot’s fifth criticism is that the transition to higher capital ratios may involve problems, and that banks may react to higher capital requirements by cutting lending rather than actually acquiring more lending.
Answer.  The “transition” point is a bit feeble. Granted there may be transition costs, but if higher capital ratios are actually the way to go, then the country will reap the benefits of that for the next hundred or two hundred years, which will make any transition costs irrelevant.
As for the possibility that banks will react to higher capital requirements at least to some extent by cutting lending, that is not a possibility: it’s a certainty. Reason is that higher capital ratios reduce bank subsidies  which in turn raises interest rates which cuts total debts and lending.
Elliot claims that “If banks do cut back on credit provision, then either the economy is likely to be slowed down, or less regulated entities will pick up the lending slack, bringing up other risks that will be covered in the next section.” The answer to that is that higher capital requirements involve removing or reducing subsidies and subsidies misallocate resources, i.e. reduce GDP. Thus far from less lending causing a REDUCTION in GDP, as claimed by Elliot, the actual effect would be to INCREASE it.

10. Shadow banks.
Elliot’s final criticism is that increased capital requirements will drive business to the shadow bank sector. The answer to that was given by Adair Turner former head of the UK’s Financial Services Authority. As Turner said, : "If it looks like a bank and quacks like a bank, it has got to be subject to bank-like safe-guards." I.e. all banks, or at least all banks above some minimum size should abide by the same rules.
Regulating one lot of banks, but not another lot makes as much sense as forcing males to abide by speed limits on the roads while not forcing females to do so (or vice versa).

There may be some flaw in MM that I have not spotted. But I’ve been through a reasonable selection of MM critics, and their criticisms are frankly pathetic.
Game set and match to MM far as I can see.

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