Farcical bank regulations.

Regulators have spent millions of hours and dollars recently hunched over their calculators, trying to work out just how far bank capital should be raised so as to improve bank safety, without demanding TOO HIGH a level of capital because that would allegedly raise the cost of funding banks by too much.

There is of course a well-known answer to the latter “cost” point, namely the Modigliani Miller theory (MM). MM basically says that if the amount of capital used to fund a bank is for example doubled, that will halve the risk per share. Ergo doubling bank capital has no effect on the TOTAL CHARGE made by shareholders for funding the bank. Ergo raising bank capital costs nothing.

A large amount of effort has been devoted to working out whether MM is 100% valid, or whether it does not actually work as per theory in the real world. For example David Miles of the Bank of England Monetary Policy Committee claimed that while the MM theory was basically right, that MM “is not likely to hold exactly”.

Why not? He doesn’t say.

But I’ll take a different approach and hopefully show that MM is indeed 100% valid, and hence that having a bank or “lending entity” funded JUST BY CAPITAL (which is what is involved in full reserve banking incidentally) would involve no additional costs at all. The different approach is thus.

Take two hypothetical banks which engage in the same type of lending (risky or safe – whatever you like). One bank is funded almost entirely by capital and the other almost entirely by depositors or other types of debt. Now assuming no taxpayer or government support for banks, what’s the difference between the risks run by those funding those two banks? The answer is “absolutely none”. Ergo there is no difference in the cost of funding the two banks! Simple.

There are of course differences between shareholders and depositors / debt, but the differences are irrelevant. To illustrate, say a bank’s assets decline to 90% of book value, that just means in the case of the shareholder funded bank that the shares would drop to about 90% of initial value. While in the case of the depositor funded bank, and assuming the bank is declared insolvent, depositors would get about 90 cents in the dollar. So shareholders and depositors are in the same position to all intents and purposes.

So where does this idea that bank capital is inherently expensive come from? Well I suspect numerous economists have been misled by various artificial and politically inspired interferences in the free market which have artificially boosted the cost of capital relative to the cost of debt.

For example some countries have deposit insurance funded by taxpayers. Now in that case obviously funding via capital will be more expensive than funding via depositors! The depositors are subsidised. In other words in such a country, to get at REAL COSTS, deposit insurance should be ignored.

Another distortion that artificially boosts the cost of capital comes from the different tax treatment of capital and debt. Indeed that seems to be the most popular criticism of MM. But of course the criticism is complete nonsense because tax is an ENTIRELY ARTIFICIAL imposition. You really have to wonder whether so called professional economists can think their way out of a paper bag. The latter nonsensical tax criticism of MM was made for example by David Elliot, of the Brookings Institution, Lev Ratnovoski, Anil Kashyap, and Urs Birchler.   

Conclusion.

The bank regulators mentioned at the outset above,  hunched over their calculators have been wasting their time. They might just as well have implemented the VERY LARGE increase in bank capital advocated by for example Martin Wolf, chief economics commentator at the Financial Times, and by Anat Admati. To repeat, that would not have raised bank funding costs.

Indeed, the process can be taken much further: have lending entities funded JUST BY SHARES, which is what is involved in full reserve banking (FR), or at least some versions of FR. That of course raises an obvious question: how about depositors? Well the answer is that under FR, depositors (i.e. people who want to be guaranteed to get $X back for every $X they deposit) simply have their money lodged at the central bank and/or put into short term government debt. No risks are taken with their money.

The net result is that banks are failure proof. The lending half of the banking industry cannot go insolvent because by definition, an entity funded just by capital cannot go insolvent. And as to depositors, their money is totally safe (or at least as safe as is possible in this imperfect world).

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P.S. (24^th Nov 2014). To add to the muddle, there is this less than inspiring Bank of England paper (“The Financial Policy Committee’s review of the leverage ratio”) which has a lot to say about the leverage ratio, but doesn’t actually explain why a low ratio will costs us more than a high ratio . . . except for a reference (p.24) to a NIESER computer model which apparently contains estimates of those costs. Unfortunately I’ve found that model impossible to access.

Anyone writing a paper which claims that X=Y should spell out in very clear language exactly why they think X=Y, strikes me.