Mark Carney thinks bank capital might be expensive.

At least that’s what Carney (governor of the Bank of England) suggested recently in Davos. According to this article, “Mr. Carney said that making banks maintain even higher levels of equity could increase their costs, and those costs would probably get passed on to the banks’ customers.”  That “expensive capital” story is often spun by commercial banks when trying to avoid better capital ratios, and it looks like Carney may have fallen for it.

So let’s go through this from the beginning. It’s not difficult: in fact it’s desperately simple.

It might seem that bank capital is expensive compared to debt (e.g. bonds or deposits) because the return demanded by shareholders is higher than that demanded by debt holders. Well that difference in return is explained by the very simple fact that shareholders are first in line for a hair-cut when the bank is in trouble. Obviously shareholders want a bigger return!

However, it’s false logic to conclude that if bank capital ratios are increased that the TOTAL return demanded by all bank funders at a particular bank (shareholders, depositors etc) will rise. Reason is that the total risks involved in running a bank are determined SOLELY by the nature of the bank’s assets (its loans and investments). E.g. a bank that specialises in NINJA mortgages obviously runs a bigger risk than one specialising in conventional mortgages.

In contrast, whether those funding the bank are composed mainly of shareholders, bond-holders or depositors HAS ABSOLUTLY NO INFLUENCE on the above “total risk”. Ergo changing the composition of funders (e.g. increasing shares at the expense of bonds or deposits) has no effect on the total return demanded by bank funders.

Indeed, the latter very simple point was the point made by Messers Modigliani and Miller, a point for which helped them get a Nobel Prize.


The messy real world.

Unfortunately in the real world, the Modigliani Miller theory (MM) doesn’t work out quite as simply as the above simple bit of theory suggests. That is, there are host of complexities (half of them unnecessary) that muddy the picture in the real world. And that is music to the ears of banksters and academics in the pay of banksters: those complexities enable them  to churn out thousands of words of waffle which actually boil down to nothing, and which don’t basically rebut the above simple theory. And that, combined with bribes paid to politicians by bankers enables bankers to avoid better capital ratios, often as not.


The tax treatment of debt.

For example, there’s the point that the tax treatment of debt is different to the treatment of shares: interest on debt can be debited to profit and loss accounts. But dividends can’t. Well that “tax” point is wholly irrelevant because tax is an ENTIRELY ARTIFICIAL imposition: it doesn’t reflect underlying economic realities.

But that’s not how some academics see it: they seem to think that because debt is good value for money on account of those tax advantages, that therefor the REAL COST of debt is lower than the REAL COST of capital.

Anat Admati touched on the latter point in a recent tweet:

If banks aren't as attractive to equity investors, maybe too much of their current value is due to debt subsidies. http://t.co/D6xGHjiTQ0
— Anat Admati (@anatadmati) January 23, 2015

Admati is professor of economics at Stanford.

TBTF.

Another flawed “bank capital is expensive” argument is thus.

Given inadequate capital ratios of the sort of that prevailed before the crunch, clearly the chance of bank insolvency is too high. And we all know who carries much of the cost stemming from bank insolvency in the case of large banks: the taxpayer.

It follows that as bank capital ratios are raised, significant costs are removed from taxpayers and loaded onto shareholders. So as capital ratios rise, the TOTAL COST of funding banks does rise. But of course that rise is due to the removal of a subsidy: an entirely justifiable removal. MM remains unscathed!


Shadow banks.

Another popular argument against better capital ratios is that the effect will just be to drive business towards the unregulated sector: shadow banks. Well the answer to that is to regulate shadow banks the same was as regular banks are regulated. Or as Adair Turner (former head of the UK’s Financial Services Authority) put it, “If it looks like a bank and quacks like a bank, it has got to be subject to bank-like safeguards..”

Of course it will never be possible to regulate every single shadow bank including the very smallest. But that doesn’t matter. As long as every institution that behaves like a bank and which has a turnover of more than roughly $10m a year is regulated, that cracks the problem.

If someone lends $100 to their next door neighbour, they’re acting as a bank strictly speeking. Clearly it would be absurd to regulate that sort of lending.