Mervy King’s bizarre arguments against very high bank capital ratios.

Mervyn King, former governor of the Bank of England, has just published a book entitled “The End of Alchemy…”.

In Ch 7 of the book he argues against the idea that the bank industry should be split in two, one half (funded just by shares) doing lending, and the other half of which accepts deposits, but which cannot lend (except to government or the central bank). Under that arrangement the first half cannot go insolvent (though King doesn’t seem to have worked that out, as is shown below). As to the second half, that’s as safe as it is possible to get in this world. (Incidentally, King sometimes refers to the lending half as “wide banks”).

That arrangement obviously involves a capital ratio of 100% for the lending half. But some of the arguments for and against that arrangement also apply to capital ratios that are high, but not up to the 100% level. For example Martin Wolf and Anat Admati advocate a 25% or so ratio, while Miles Kimball (economics professor at the University of Michigan) advocates 50%

King’s first objection to very high capital ratios comes in the paragraph starting “So why hasn’t the idea been implemented?” That first objection actually comes in two parts. First King says “Banks will lobby hard against such a reform.”

Yes I bet they will. Doubtless they also lobby against controls on laundering Mexican drug money. But any such lobbying is a total and complete irrelevance: the only important question is whether much higher bank capital ratios (or curtailing the laundering of Mexican drug money) is in the best interests of the country as a whole.

Second, and also part of his first objection, King says the transition to very high capital ratios “…could be disruptive, forcing a costly reorganisation of the structure and balance sheet of existing institutions.” Well the simple answer to that is that the existence of high upfront costs is not an argument against ANYTHING, whether it’s demolishing an office block and re-building it, or anything else. The only important question is whether benefits outweigh costs in the long run, a point which I’d imagine 95% of taxi drivers understand.

Moreover, it’s debatable as to whether the latter transition really would be costly. Milton Friedman’s view was that it WOULDN’T. As he put it in his book A Program for Monetary Stability, “There is no technical problem in achieving a transition from our present system to 100% reserves easily, fairly speedily and without any serious repercussions on financial or economic markets.”

Well the above pair of objections to higher capital ratios aren’t too clever are they? I’d expect an intelligent school leaver to see the flaw in King’s arguments there.


Intermediation.

King’s second objection to narrow banking has to do with intermediation, and answering it would take too long. So I’ll skip that in this article. I’ve actually dealt with all relevant points in earlier articles.


Bank insolvency.

King’s third objection does not consist of one single clear point. Rather it’s a collection of different points.

The opening sentences of this third objection are just below. But first I’d better explain that King’s phrase “radical uncertainty” which appears in the passage below refers to big problems that suddenly appear from nowhere, like the 2007/8 bank crisis: so called “black swan” events.

Anyway, his third objection starts…

“Third, and most important of all, radical uncertainty means that it is impossible for the market to provide insurance against all possible contingencies, and one role of governments is to provide catastrophic insurance when something wholly unexpected happens. Ending alchemy does not in itself eliminate large fluctuations in spending and production.”

(By “alchemy”, King means (roughly speaking) “borrow short and lend long”. I’ve put his definition of the word at the end below. As you’ll see, his “alchemy” is a strange concept. But “borrow short and lend long” is the best translation into normal English I can think of.)

Well it’s true, as King says, that curtailing borrow short and lend long, or implementing very high capital ratios will not of itself eliminate “fluctuations in spending and production”.  The advocates of very high capital ratios have never claimed they do. But the latter changes do make banks more stable.

King’s criticism is like criticising cars because while they transport people in comfort and at quite a speed, they only carry about four people and don’t go as fast as airliners. Cars (and this may be news to King) are a big improvement on horses and carriages. That’s an achievement.

Moving on, King then makes various points which I could criticise, but I’ll concentrate on his worst mistake which is that he quite clearly does not understand that wide banks cannot go insolvent, nor does he understand the basic money creation process which private banks engage in.

He says, “Ensuring that money creation is restored to government through the requirement for narrow banks to back all deposits with government securities does stop the possibility that runs on the banking and shadow banking sectors will transmit shocks at rapid speed right across the financial sector, as happened to such devastating effect in 2008. But the risk from unexpected events is then focused on the prices of assets held directly by households and businesses and on the solvency of wide banks.”

Now hang on. As King himself rightly points out, wide banks (the half of the industry which lends to mortgagors, businesses, etc) are funded just by equity. That being the case, how is it possible for them to go insolvent? Insolvency means not being able to pay creditors when debts are due for settlement. But a bank funded just by equity doesn’t owe anything to anyone!

Of course it’s theoretically possible that a bank becomes indebted to TRADE CREDITORS (e.g. those who supply it with electricity, paper, computers etc) and that the loans the bank has made are so hopeless that there is no cash available from those loans when they’re due for repayment. But nothing like that has ever happened in the banking world far as I know. That degree of failure would be far worse than occurred with Lehmans or Northern Rock.

The next passage which indicates that King basically does not understand wide banks reads, “Although wide banks cannot create money in the form of deposits, they can still borrow short and lend long.”

Complete nonsense. It’s the very fact of a bank borrowing short and lending (long or short) that results in money creation. That is, if a bank accepts a deposits totaling £X and lends that on, then borrowers have £X to play around with, and depositors still see a total of £X (credit balance) on their bank statements. £X has been turned into £2X. In contrast, if a bank borrows long (e.g. depositors cannot get access to their money without say 3 or 6 months notice) that so called money is not counted as money in most jurisdictions. So no money multiplication takes place.

As King himself correctly pointed out a few paragraphs earlier, a wide bank is one funded just by equity, i.e. not funded by short term debt. As he put it…

“If deposits must be backed with safe government securities, then it follows logically that all other assets, essentially risky loans to the private sector, must be financed by issuing equity or long-term debt, which would absorb any losses arising from those risky assets.”


Conclusion.

Mervyn King was head of one of the world’s leading central banks for a decade or so. You have to wonder whether he was up to the job to judge by his book. If you want to know why the 2007/8 bank crisis erupted, perhaps you now have part of the answer.


King’s definition of “alchemy”.

His definition runs as follows (and if you find it a mouthful, so do I).

“By alchemy I mean the belief that all paper money can be turned into an intrinsically valuable commodity, such as gold, on demand and that money kept in banks can be taken out whenever depositors ask for it. The truth is that money, in all forms, depends on trust in its issuer. Confidence in paper money rests on the ability and willingness of governments not to abuse their power to print money. Bank deposits are backed by long-term risky loans that cannot quickly be converted into money. For centuries, alchemy has been the basis of our system of money and banking. As this book shows, we can end the alchemy without losing the enormous benefits that money and banking contribute to a capitalist economy.”

Were you somewhat bamboozled by that definition? I was.

For example, where are these people who apparently think that “all paper money can be turned into an intrinsically valuable commodity, such as gold, on demand and that money kept in banks can be taken out whenever depositors ask for it”?

Anyone with a grain of common sense knows that if the entire population tried to withdraw their stock of money from banks and turn it into gold or anything else “intrinsically valuable”, the result would be chaos. For a start, every bank would immediately go insolvent and we’d have rampant inflation!

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P.S. 19th March 2016.   There is another none too flattering review of Mervy King’s book (by Joseph Huber) here.
 

P.S. 29th March 2016.  As distinct from my above article which deals with just one chapter of King's book, there was a long letter in the Financial Times recently which criticised the BASIC IDEA in King's book. (Letter title: "Banking system sometimes needs a does of radical uncertainty.")