Vince Cable suckered by banks.

Banks run rings round politicians and regulators. But some politicians are particularly gullible, and the UK’s “business secretary” Vince Cable is one such.

This article by Nils Pratley entitled “Vince Cable has swallowed the bankers' line on capital” gets most of the details right on the subject of the gullible Vince Cable.

Vince Cable’s argument is simply that the tighter are bank regulations, the less will banks lend, which (all else equal) will reduce GDP. Well the simple answer to that is that there is no reason for “all else to be equal”. In particular, any deflationary or growth inhibiting effect stemming from stricter bank regulation can easily be countered by standard stimulatory measures: interest rate cuts, a larger deficit or whatever. Or to put it more bluntly, if demand is not sufficient to bring full employment, then more of the stuff that enables households to “demand” goods and services should be put into household pockets, and that “stuff” is called “money”. Plus of course, public spending can always be raised.

Nils Pratley goes wrong, however, when he says “asking banks to hold more capital should not impede lending.” Actually increasing bank capital requirements WOULD RAISE the cost of bank loans by a finite amount. Reason is that given very low capital ratios, taxpayers effectively carry much of the risk involved in bank lending, which is a subsidy of banks. I.e. as capital ratios rise, that subsidy ipso facto is withdrawn. (For more details on that, see the work featured at the top of the column to your left, in particular section 1.4 under the heading “Bank funding cost increases due to subsidy withdrawal.”)

However, the fact of raising the cost of one product (which necessarily means reducing the cost of all other products) WILL NOT reduce GDP if the reason for the latter rise in cost stems from removing an unwarranted subsidy. In fact the effect will be to INCREASE GDP, because unjustified subsidies distort markets and cut GDP.

Mervyn King.

In support of his claim that increased capital ratios increase rather than reduce lending, Nils Pratley quotes Mervyn King. Pratley says, “The key point is that more capital and more lending go hand-in-hand, as Sir Mervyn King stressed time and again when he was governor. "Capital supports lending and provides resilience.””

Now wait a moment. Obviously if a sugar daddy appears from nowhere and supplies more bank capital, then bank lending will rise all else equal. But more bank capital, if it materialises, won’t come from sugar daddies.

In the real and harsh world, more bank capital will only be supplied if it is PAID FOR. As explained in the above mentioned section 1.4, the ACTUAL AMOUNT banks will need to pay for more capital won’t be prohibitive (largely because of the Modigliani Miller theory). But banks will certainly have to pay a FINITE AMOUNT for more capital.

Conclusion.

Raising bank capital requirements WILL REDUCE lending (and debts). But those raised requirements by their very nature mean the removal of a subsidy for banks, and subsidies distort markets and reduce GDP. Thus raising bank capital requirements would cut lending and debts, but RAISE GDP.

But whether Vince Cable understands all that is pretty doubtful.