Tuesday, 26 April 2016
Sir John Vickers shifts his ground.
Sir John Vickers was chairman of the main British investigation into the 2007/8 bank crisis. That investigation’s official title was the “Independent Commission on Banking” – also referred to as the “Vickers commission”).
Anyway, it’s nice to see John Vickers in his latest publication come round to something nearer to what I’ve been advocating for some time. In the ICB report, he and his committee advocated a very small increase in bank capital ratios, and on the grounds that a big increase in capital ratios would impose costs on banks.
The flaw in that idea was set out by the two Nobel laureate economists, Franco Modigliani and Merton Miller in their “Modigliani Miller” theory (MM), which shows that capital ratios have no effect on funding costs, a theory which the ICB dismissed.
If high capital ratios do increase costs, it’s strange that corporations’ capital ratios are all over the place: everything from about 20% to 90%. Google has ratio of 90% and is doing just fine, far as I know.
At any rate, in his latest work, John Vickers is far more at ease with much higher capital ratios. He cites Anat Admati with approval - she advocates a capital ratio of 25 to 30% (p.6-7).
The Modigliani Miller Theory.
MM is one of those beautifully simple theories, a bit like E=MC2 which just grabs you by the throat – at least for those who understand it, it’s beautiful. Unfortunately as is the case with most simple theoretical insights, the theory then induces a collection of time wasters and hangers-on to jump on the band wagon and advocate a series of changes to, or criticisms of the original theory which are basically just a waste of ink and paper.
It’s the same with religion: original thinkers like Jesus and Buddah produce something worthwhile. But they’re followed by theologians, hate preachers etc who end up trashing the religion.
In the case of MM, the most popular criticism of it is that the tax treatment of capital and debt is not the same, thus MM supposedly does not work out in the real world as per theory. The flaw in that idea is that tax is an ENTIRELY ARTIFICIAL imposition, thus for the purposes of calculating REAL COSTS AND BENEFITS, it should be ignored.
Vickers critises that alleged “tax” weakness in MM, and rightly so (p.7).
He then says “The other main reason why banks and their shareholders are averse to equity funding – whether by new issuance or retained earnings – is that, by reducing insolvency risk, it has benefits that flow to creditors and are not fully appropriated by the shareholders themselves.11 Reducing too-big-to-fail risk, which falls on the public as contingent creditor if it happens, is a prime instance of this effect. More bank equity reduces the likelihood and scale of public bail-out. So long as there is any prospect of bail-out, debt funding is effectively subsidised relative to equity funding.”
So to summarise, Vickers seems to be saying that the two main criticisms of MM are invalid. Well I’ll drink to that!
A 100% capital ratio.
But having advocated substantially higher capital ratios, Vickers than says “None of this is to say that banks should be entirely funded by equity, which would eliminate bank deposits and the liquidity services that they provide.”
John Vickers must know (or perhaps he doesn’t) that that’s nonsense. Under a 100% capital ratio system (or “100% reserves” as Milton Friedman called it), the state aims to supply the economy with whatever amount of money is needed to keep the economy operating at capacity. Thus the idea that “bank deposits” vanish, is just nonsense. The main difference is that under 100% reserves, those deposits are kept in a totally safe manner, whereas under the existing system, they’re put at risk.
Another point about banking which John Vickers still apparently doesn’t understand (not that many other people do) is thus.
It’s blindingly obvious that if banks (or more generally, entities that lend) have to fund themselves entirely out of equity, that that will raise the cost of funding those banks, and that in turn will have a deflationary effect. The John Vickers of this world then jump to the conclusion that VERY high capital ratios are damaging.
Well the simple solution to that little problem or “non problem” is stimulus – to put it bluntly, having the state print money and spend it and/or cut taxes. There is no limit to the amount of stimulus that can be implemented that way (as pointed out by Mosler’s law). Thus any deflationary effect of high bank capital ratios is a total and complete non problem.
Put another way, there is a choice between two alternatives. The first involves relatively low bank capital ratios, relatively small amounts of base money in the hands of households and high levels of household debt. Second, we can have high bank capital ratios, a larger amount of money in the hands of households and lower household debts.
As I explain in this work, the second option resembles a free market more closely than the first, thus the second is the GDP maximising option.