Martin Sandbu’s none too clever idea on bank capital.

Sandbu, concludes a recent article in the Financial Times on bank capital ratios with: “We may be uncertain where the right number is, but until equity requirements are manifestly harming the broader economy (and not just banks’ bottom lines), it is safest to keep making them tougher.” (Article title: “Banking systems remain unsafe”).

Well the first problem there is this. How on Earth do we know when excessive bank capital ratios are “harming the economy”?

An excessive ratio will not show up as excess unemployment for the simple reason that whatever the deflationary effect of raising bank capital, government can always counteract that with stimulus (fiscal and/or monetary). Of course that’s on the optimistic assumption that those in power have heard of Keynes and know what stimulus is, which is a debatable assumption. But I’m an optimist, so let’s assume those in power are not completely economically illiterate.

Next, would a substantial contraction in the bank industry prove that capital ratios were excessive? Well the trouble with that idea is that the bank industry in the UK has expanded a whapping ten fold relative to GDP since the 1970s. So if the bank industry HALVED in size it would still not be back to its 1970s size, and there were no howls of anguish that I remember in the 1970s to the effect that the bank industry was too small.

Next, whence the assumption that raising capital ratios constrains the bank industry at all? High capital ratios do not seem to constrain other industries: for example Google is 90% funded by capital. Far as I know, Google is not a disastrous flop.

And apart from the latter evidence that high capital ratios do not constrain an industry, there is a big theoretical flaw in the “constrain” idea, as follows.

Equity holders only demand a higher return than depositors or bond holders because equity holders run a bigger risk: in the event of a bank going under, equity holders are wiped out before bond or deposit holders take any sort of hit.

However, it’s a huge mistake to think that therefor if capital ratios are raised, the cost of funding banks rises: reason is that the capital ratio rises X times, then the risk run by equity holders must be 1/X what it previously was. And if you want proof of that consider two banks which are identical in all respects except that one is funded entirely by equity and the other entirely by bonds or deposits.

The risk of the bank’s assets declining to Y% of their book value is exactly the same in each case because that risk is determined by the nature of the loans and investments made by the bank, not by the way it is funded (e.g. NINJA mortgages versus sensible mortgages). And the nature of the two banks’ assets is the same.

Incidentally, the idea that a bank can be funded entirely by deposits or bonds is a trifle dishonest since any claim by a bank that all of those funding a bank are guaranteed their money back is patently dishonest: reason is that if the bank’s assets do decline to Y% of their book value, then clearly the bank cannot repay depositors or bond holders.

But then as others have pointed out, even the equivalent claim by a conventional bank (funded by say 5% capital and 95% bonds and depositors) is dishonest, since if assets decline to less than 95% of book value then in principle the bank cannot repay depositors and bond holders, i.e. the bank is technically insolvent.

Anyway, returning to the above point that equity holders only demand a higher return than depositors or bond holders because of the extra risk run by equity holders, that difference in risk is a mirage for a second reason: while depositors do not charge for the risk they run, banks are still charged for that risk via state run deposit insurance (e.g. FDIC in the US). At least banks ought to be charged for that risk.

Of course given that politicians have a habit of doing whatever banksters tell them to do (in exchange for – er – “generous donations to electoral expenses”), banks often do not get charged for deposit insurance, or they do not get charged the full and appropriate amount.

But assuming they are charged the right amount, then the total charge to banks made by equity holders and depositors and bond holders ought to be the same. At least the above is a strong case for thinking that the total charge will be very similar.

Hence raising capital ratios ought to have little effect on the cost of funding banks.

And the final joke is that at the time of writing, the return on bonds is higher than the return on equity.

All of which makes a bit of a nonsense of Sandbu’s claim that at some point, as bank capital ratios are raised, we will be able to detect when they have risen too far.