Douglas J Elliot’s flawed Brookings Institution article.

As an advocate of much higher bank capital ratios (and preferably a 100% ratio) I’m always much encouraged by the incompetence of those who argue against higher capital ratios.

Douglas J.Elliot tries to argue in this Brookings Institution article that improved bank capital ratios would come at a cost.

His first argument is that “interest payments on debt are tax-deductible while dividend payments on common stock are not.” Thus if banks had to have more capital, that would raise their costs. Well the flaw in that argument should be obvious: tax is an ENTIRELY ARTIFICIAL imposition. It has precisely and exactly nothing to do with underlying REAL COSTS.

I shouldn’t have to illustrate that point because it should be obvious, but evidently I’ll have to, so here’s a nice simple illustration that even those who write for the Brookings Institution will hopefully understand.

If government taxed red cars more heavily that blue cars,that would raise the retail price of red cars. But that would not be evidence that the REAL COST of producing red cars was any more than the cost of blue cars. Hope that’s clear now.

But I’ve got good news for Douglas J.Elliot: I’ve come across more than one other so called “economist” who doesn’t get the point that the change in price brought about by a tax is an entirely ARTIFICIAL change in price.

Point No.2: TBTF.

Elliot’s second point makes the same mistake as above first point. That is, he argues that where a bank is funded by debt, the bank is not charged as much as it should be for that debt since the relevant creditors know or suspect they are protected by the Too Big To Fail subsidy. So to that extent, having banks funded by capital rather than debt would raise bank costs.

Well of course! But there again, the TBTF subsidy is ENTIRELY ARTIFICIAL. It does not reflect REAL UNDERLYING costs.

Bizarrely, Elliot actually concedes the point that TBTF and other bank subsidies are an entirely artificial contrivance. He says “Advocates of higher capital correctly point out that these subsidies represent policy distortions and ought to be done away with..” But for some reason he still clings to his claim that deposits are an inherently cheaper method of funding a bank than capital.

Third: asymmetric information.

Elliot then claims that since management knows more about a bank than potential purchasers of its shares, and because management is likely to be overoptimistic about the bank’s prospects, potential share buyers will want a discount when a new issue of shares is offered. Thus, so he argues, having depositors fund a bank is an inherently cheaper method of funding.

Well the first answer to that is that is “bonds”. Bonds are a sort of compromise between shares and deposits. That is, like deposits, a bank’s liability is fixed in dollar terms in the case of a bond. But like shareholders, bond holders are not the most senior type of creditor. And when a bank issues bonds, exactly the same “assymetric” point applies: that is, potential bond holders want a discount.

As to depositors, one important reason they don’t demand a discount when supplying a bank with funds is that most depositors are protected by taxpayer funded guarantees: again an entirely ARTIFICIAL contrivance.

A second reason depositors don’t demand a discount is that they are senior creditors. But of course it’s nonsense to deduce from that that funding a bank almost entirely via depositors is therefore an inherent cheaper method of funding. Reason is that the higher the proportion of a bank’s creditors that are made up of depositors, the less the significance of the word “senior”. To illustrate, if 99.9% of a bank’s creditors are depositors and 0.1% are shareholders, then the word “senior” is almost meaningless. Who are depositors senior to? Almost nobody!!

Conclusion.

Given the poor quality of Elliot’s first three arguments against higher capital ratios, I can think of better things to do than examine his fourth, fifth and sixth reasons.