Imposing higher capital requirements on banks does not hit growth.

The response of banksters to Basel and other types of bank regulation is entirely predictable. They claim that those regulations make lending more expensive, which in turn allegedly hits economic growth. And you can tell how concerned banksters are about growth from the fact that they brought about the most catastrophic REDUCTION in growth since WWII: the recent crisis.

The Institute of International Finance, as The Economist points out, is banks’ main lobbying body. And I’ve set out below a few quotes from a publication of theirs in which they try to claim that better capital requirements will hit growth. (See section below entitled “Institute of International Finance Quotes”).

But first, there are powerful and quite simple reasons for thinking that imposing higher capital requirements on banks has no effect on growth at all. Indeed, a 100% capital requirement (which is way above the level contemplated by Basel, Dodd Frank, etc) would not hit growth. Reasons are as follows.

Small banks.

First, as to relatively small banks which are covered by some sort of self-funding FDIC type insurance system, there is no taxpayer funded subsidy. So those banks could be allowed to get away with inadequate amounts of capital. But frankly, the sort of regular failures of small banks that we see in the US doesn’t seem like any way to run a railroad. So requiring small banks to hold more capital certainly wouldn’t do any harm.

Large banks.

Large banks are a different kettle of fish.

With a large bank, if capital is not enough to enable a bank to weather a crisis, then someone else carries the risk. And of course it’s the taxpayer. But taxpayer backing for a commercial bank equals a subsidy. And subsidies amount to a misallocation of resources, as is explained in introductory economics text books.

So how much capital should banks hold? Well STRICTLY SPEAKING, banks should be funded ENTIRELY BY capital rather than by traditional retail deposits or short term funding from money markets (which Northern Rock relied on to a large extent). Reason is that there is a finite possibility that a bank’s assets turn out to be TOTALLY WORTHLESS.

Of course the latter outcome is very unlikely. That is, it’s quite common for a bank’s assets to be worth only 90% of its liabilities, with the bank keeping quiet about it and eventually recovering. As to assets turning out to be worth only 80%, 70%, 60% etc of liabilities, obviously the likelihood diminishes as those percentages decline to zero.

But there is always FINITE POSSIBILITY that assets turn out to be worthless. Thus strictly speaking, if we’re to have no bank subsidies, banks should be funded entirely by capital.

Miller Modigliani.

As to the argument, much favoured by banks, namely that funding by capital is inherently more expensive than funding via depositors or similar, that claim is basically demolished by the MM theory. MM states (approximately) that the risks run by given bank are a given, thus the total charge made by those covering those risks for accepting said risks is not affected by altering the number of people or amount of capital that covers those risks.

E.g. if a bank is currently funded 10% by capital and 90% by depositors, and depositors are suddenly told they lose everything if the bank’s assets turn out to be worthless, then the total payment made by the bank to loss absorbers or “risk coverers” ought to remain the same.

But even if higher capital requirements do result in a significiant proportion of depositors fleeing to 100% safety (like National Savings and Investments in the UK), i.e. even if higher capital requirements do result in banks lending less, what of it?

Banks constantly try to tell us that the result is reduced growth, and of course that is indeed the result, ALL ELSE EQUAL. But there is absolutely no reason for all else to be equal. That is the deflationary effect of reduced lending can perfectly well be made good by standard stimulatory measures. (Personally I prefer a mix of monetary and fiscal measures, i.e. simply having the government / central bank create and spend new money into the economy).

Moreover, a regime where there is no possibility of taxpayer funded bail outs for banks is a subsidy-free regime. That is, it’s a regime that contrary to the claims of banks, results in HIGHER GDP than a regime that involves subsidies.

Institute of International Finance Quotes.

The following three quotes come from an IIF publication entitled “Comments by the Institute of International Finance on the Basel Committee for Banking Supervision's Consultative Documents” (April 2010). The quotes all imply that higher capital requirements will impede growth. Doubtless you’ll find more passages along the same lines if you word search for “capital”,“growth”, etc.

* In addition to appropriate design and calibration of the specifics, the success of the revised capital requirements and the new liquidity regime will depend on appropriate timing. The BCBS is fully aware of the need not to disrupt a fragile recovery. (BCBS is the Basel Committee on Banking Supervision).

* However, additional work on the side of both the industry and the regulatory community may well be needed in order to achieve revised capital and liquidity frameworks that respond adequately to the twin goals of system resilience and sound economic growth.

* Working Group's projections conclude that the current mix of specifically targeted reforms would combine – against the backdrop of an already fragile global expansion – to hinder medium-term credit growth.  This is essential for the Committee to meet its goal to “ensure that the sum of these measures does not result in banks holding excessive buffers beyond what is necessary to maintain a resilient banking sector.”