Thursday 23 July 2015

Bank capital is not expensive.


Bank capital SEEMS TO BE expensive because bank shareholders demand a higher return than bondholders or depositors.  The flaw in that idea was pointed out by Franco Modigliani and Merton Miller, and they got Nobel Prizes for that (amongst other things).

The flaw in the idea that bank capital is expensive is very simple and as follows.

If a bank’s capital ratio is doubled, the risk per shareholder is halved, thus the amount that each shareholder will charge (per dollar of shares) for bearing risk will also halve. Thus the cost of an ADDITIONAL dollar of capital is no more than the cost of an additional dollar of debt.

The Modigliani Miller theory HAS BEEN criticised, but the criticisms don’t amount to much, far as I can see. In particular, the most popular criticism according to this recent article by James Kwak is the idea that in the REAL WORLD, debt is cheaper than capital because “companies can deduct interest payments on debt from their taxable income, but they can’t deduct dividends paid to shareholders” to quote Kwak.
 

I also pointed out about a year ago that that “tax” point seems to be the most popular criticism of MM. (see top of p.25).

The flaw in that criticism is that tax is an entirely artificial imposition on banks, or indeed any corporation. That is, tax, while it is obviously a cost as viewed by the entity that pays the tax, is not a real cost from the point of view of the country as a whole.

To illustrate, if red cars were taxed more heavily than blue cars, would that mean that the REAL COST of red cars was higher than that of blue cars? Obviously not. Thus that would not be a reason for the country as a whole to give any sort of preference to blue cars.

By the same token, the above point about tax and banks is not a reason to give any sort of preference to bank debt as compared to bank capital.

9 comments:

  1. Don't the share owners also own the capital? If so, the basic premise of this post is incorrect.

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    Replies
    1. Yes: to own shares is to own capital. Why does that make the premise incorrect?

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    2. Well, you write "If a bank’s capital ratio is doubled, the risk per shareholder is halved".

      The risk of loss is unrelated to the amount of capital at risk. These are two different concepts.

      If a loss occurs, the entire loss is charged against the invested capital (which is all owned by stockholders).

      So what good does doubling the amount of invested bank capital do? It doubles the amount of possible losses before the bank goes bankrupt. Stated another way, doubling the amount of invested capital also doubles the amount of potential shareholder losses.

      Why do shareholders resist increased capital ratios? Increased ratios increase potential shareholder losses AND spread any profits over increased amount invested capital which has the effect of reducing the earnings per invested capital.

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  2. Hi Ralph !

    OK bank capital is not expensive using the risk adjusted price to shareholders to an individual bank but at some point of increasing capital ratio there must be a cost at the Macro economic level.

    As Capital ratio increases the creation of new credit to borrowers is reduced because credit creation is replaced with entrustment. Credit has been historically been one of the biggest contibuiors to the general economic prosperity of the economy, if handelled correctly.

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    Replies
    1. Dinero,

      I agree: bank funding does become more expensive as capital ratios rise, but only in that bank subsidies are withdrawn. I should have mentioned that above. And as a result, loans become more expensive.

      By "subsidies" I mean things like the $13trillion of lender of last resort loans which the Fed handed out and which should have been at Bagehot's "penalty" rates, but which were actually nearer a zero rate. And then there's deposit insurance which in the UK is funded by taxpayers, not banks themselves.

      And subsidies do not make economic sense: they misallocate resources. Ergo GDP, contrary to what you might expect, ought to rise when loans become more expensive.

      I enlarged on that point in the post just prior to the above one ( i.e. a day or two ago).

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    2. My comment s said that the bank capital cost does not become more expensive.

      Its at the macro economc level that there must be a cost at some point from entrusting existing spending power in replacement of creating new spending power.

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    3. Not sure what you mean by “entrusting existing spending power in replacement of creating new spending power”. All I can think of is that you’re alluding to the fact that as capital ratios rise, the scop for private money creation declines and thus that more money has to be put in circulation by the state. That’s true, but I don’t see the problem. Some states have put unprecedented amounts of base money into circulation as a result of QE, and the sky has not fallen in.

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  3. Roger,

    This blog system won’t publish your most recent comment so I’m doing it manually. Your comment was:

    Well, you write "If a bank’s capital ratio is doubled, the risk per shareholder is halved".

    The risk of loss is unrelated to the amount of capital at risk. These are two different concepts.

    If a loss occurs, the entire loss is charged against the invested capital (which is all owned by stockholders).

    So what good does doubling the amount of invested bank capital do? It doubles the amount of possible losses before the bank goes bankrupt. Stated another way, doubling the amount of invested capital also doubles the amount of potential shareholder losses.

    Why do shareholders resist increased capital ratios? Increased ratios increase potential shareholder losses AND spread any profits over increased amount invested capital which has the effect of reducing the earnings per invested capital.


    My answer:

    “So what good does doubling the amount of invested bank capital do?” Answer: it doubles the size of losses that a bank can made before taxpayers have to start rescuing depositors (assuming the simple case of where a bank is funded just by shares and deposits, i.e. there are no bondholders). There is absolutely no excuse for taxpayers having to bail out banks, is there?

    “Why do shareholders resist increased capital ratios?” Because, as implied above, they want to keep the profits when profits are made, and have taxpayers carry the losses when losses are made.

    “..which has the effect of reducing the earnings per invested capital.” Answer: I couldn’t care less if profits go up, down or sideways. The important point is that taxpayers aren’t on the hook. If relieving taxpayers of any liability means shareholders earn less, that’s just tough luck. That’s free markets.

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  4. Thanks for reproducing my second comment in your second comment/reply.

    Actually, my second comment is visible as a reply to your first reply, all as a reply to my first comment. Confused? I am thinking that the blog software is handling each initial comment as a thread, thus grouping later comments/replies on each initial comment.

    Back to the issue of banks, certainly more bank capital increases the isolation of taxpayers. Other ways of protecting the taxpayer include requiring more down payment (more skin in the game) and stricter loan standards (who qualifies for a bank loan).

    I think it is important to prevent excessive inflation. Inflation usually precedes bank collapse (which is when the taxpayer is brought into the economy saving mode). Inflation is usually the result of excessive bank lending or excessive government money creation (which is also usually borrowing based). I much prefer a stable and somewhat predictable economy.

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