Dimon claims lower capital ratios enable banks to lend more.

David Andolfatto of the St Louis Fed draws attention to a claim by Jamie Dimon of J.P.Morgan, namely that with lower capital ratios, banks would be able to lend more. Dimon’s exact words were:

“It is clear that the banks have too much capital. We think it’s clear that banks can use more of their capital to finance the economy without sacrificing safety and soundness.”

As Andolfatto says, “It is hard to make sense of this.”

Well certainly the above phrase of Dimon’s suggests that money supplied to bank in the form of capital is somehow locked in a safe and not used. Then when that capital is converted to deposits, dollars are released which can be loaned out. Clearly that’s nonsense.

In fact, all else equal, if capital is converted to deposits, the amount the bank can lend out actually DECLINES, contrary to Dimon’s suggestion. Reason is that depositors can withdraw their money at short notice, whereas shareholders can’t. Thus a bank can lend out a higher proportion of shareholders’ money than depositors’ money.

Also, and assuming the Modigliani Miller theory is correct, which I think it is, changing the way a bank is funded (e.g. more deposits and less capital) has no effect on the cost of funding it. So to that extent, changing the capital / deposit ratio shouldn’t affect the amount a bank lends.

Another possibility is that there is a flaw in MM, and that funding via deposits really is cheaper than via capital, even after taking the cost of deposit insurance into account. Unfortunately the criticisms of MM are all over the place – see p.24 here under the heading “Flawed criticisms of Modigliani-Miller”.

However the clinching argument against low capital ratios (indeed, the clinching argument for a 100% capital ratio, i.e. full reserve banking) is that the more the extent to which banks are funded via deposits, the more they are able to print money or create money out of thin air. And that “freedom to print” amounts to a subsidy of money lenders (aka private banks). I set out the reasons here.

So to summarize, my hunch is that the costs of funding a bank with a low capital ratio are indeed lower than in the case of a high capital ratio or 100% ratio, thus Dimon is right. But that apparent advantage of low capital ratios stems so to speak from the fact that low capital ratio banks have usurped the state’s right and responsibility to provide the country with the right amount of money. Put another way, the right to create money is effectively a subsidy of such banks.