Wednesday, 4 February 2015
Joke: removing bank subsidies makes all bank funders shareholders.
It is widely accepted that bank capital should be raised and indeed that is happening. But there is much argument as to exactly HOW FAR it should be raised.
Capital ratios (i.e. the ratio of capital to total assets or liabilities) used to be very roughly 5%. They’re being raised to roughly 10%. And Martin Wolf (chief economics correspondent of the Financial Times) argues the ratio should be about 25%. Anat Admati (professor of economics at Standford) argues likewise. And some advocates of full reserve banking (e.g. Milton Friedman and Laurence Kotlikoff) argue or have argued the ratio should be 100%. (To be accurate, under full reserve, the banking industry is split in two: on half accepts deposits and lodges those deposits in a totally safe manner - i.e. it doesn’t lend to mortgagors or businesses. The other half lends, but it’s funded just by shareholders. And that by definition equals a 100% ratio.)
Now I suggest all arguments over bank capital are a waste of time and for the following reasons.
It is widely accepted that banks should not be subsidised, and indeed subsidies are being VERY SLOWLY withdrawn despite complaints from banksters. Banksters after all are keen on “socialism for the rich”.
But if and when all subsidies ARE WITHDRAWN, then all of those who fund banks (including bond-holders and depositors) become shareholders! That’s “shareholder” as in “anyone who stands to lose their entire stake in a bank if the bank’s assets decline in value to zero”.
To be more accurate, when all subsidies (including lender of last resort at favourable rates of interest) are withdrawn, bond-holders and depositors become a form of PREFERENCE shareholder since ordinary shareholders in the bank are still first in line for haircuts in the event of problems.
So the provisional conclusion is that the whole argument over capital ratios is hot air. That is, with a view to maximising bank safety, capital ratios might was well be raised to Martin Wolf’s 25% or so. And as to the 100% advocated by proponents of full reserve banking, well there might be something wrong with full reserve banking, but the 100% ratio isn't a problem.
Self insuring depositors.
It could be argued that deposits who are insured the FDIC way are not subsidised, and that that might be a cheaper way of funding banks than funding via capital. (Premiums for FDIC insurance are paid by banks, and the cost of that inevitably gets passed on to depositors).
Well FDIC type insurance is not a subsidy as long as there is no undertaking by government to come to the rescue in the event of the insurer itself failing or not having the funds to rescue a set of depositors. But in that case, depositors are shareholders in the sense that in the worst case scenario they stand to lose their money.
But let’s examine this in more detail. To keep things simple, suppose the chance of a bank’s assets being totally wiped out in any one year is one in a hundred, and that that’s the only risk. In that case, the FDIC type insurer would charge a premium of 1% (plus something for profit). And that gets passed on to depositors.
So the total return depositors would want would be the going rate for a risk-free loan plus 1%.
Now in the latter scenario, what return would shareholders require? Well their chance of being wiped out is also 1%. So they’d want a return of 1% over and above the going rate for a risk-free loan: no different to what depositors would look for!
Money market mutual funds.
As distinct from the above theory, there is also EVIDENCE stemming from recent changes to the rules governing MMFs that capital is not expensive. The change is that MMFs which invest in anything other than government debt will not be allowed to promise not be break the buck. That is, stakes in those MMFs will have to FLOAT in value rather than (as has been normal practice to date) having each unit of “stake” fixed at one dollar. In short, those investing in those types of MMFs are being turned into shareholders. And remember that MMFs are very much “bank like” entities.
But I haven’t heard any stories about those MMFs going out of business because of the alleged high cost of capital.
The whole idea that bank capital is expensive seems to be flawed.