Sunday, 9 November 2014

The bank capital ratio shambles.

A Bank of England publication entitled “The Financial Policy Committee’s review of the leverage ratio.” appeared recently.
The FPC proposes raising bank capital ratios from the risky 3% or so that prevailed prior to the crisis to 3% plus a teensy bit.
Obviously members of the FPC have been promised various favours (perhaps knighthoods and peerages) on condition they produce a lot of hot air but don’t suggest any really effective changes to the banking industry.
Anyway, enough sarcasm. There is actually a serious theoretical flaw in the publication which is that it totally ignores (apart from a minor mention in a footnote) one of the most fundamental ideas or theories governing bank capital ratios, and that is the Modigliani Miller theory.
According to MM, so far as bank funding costs go, it doesn’t make a scrap of difference how a bank is funded. It can be funded 10% by capital and 90% by deposits or the other way round. IT MAKES NO DIFFERENCE!!!!!!!!!!
But here we have a BoE committee getting worked up about the alleged increased bank funding costs involved in raising capital ratios from a miserable 3% to a miserable 3.5% or whatever.
Someone is making a serious mistake.
Either those two Nobel Laureates, Modigliani and Miller have got it all wrong, or BoE officials and other bank regulators round the world have.
And the FPC are perfectly clear that they think significant increased funding costs DO ARISE from increased capital ratios (1.).
But it’s not just Modigliani and Miller who the BoE are implicitly saying have made an enormous mistake. There is also Laurence Kotlikoff (professor of economics in Boston).
Kotlikoff advocates a version of full reserve banking (2.) under which entities that lend to mortgagors, businesses etc are funded JUST BY shareholders (or stakeholders who are effectively shareholders). So never mind the BoE’s 3% ratio: Kotlikoff is advocating 100%. And then there is Martin Wolf (3.), chief economics commentator at the Financial Times who advocates a capital ratio of about 25%.
To repeat, someone is making a SERIOUS MISTAKE here. Either the BoE FPC is right and Modigliani, Miller, Kotlikoff and Wolf are wrong, or it’s the other way round.
As to the possibility that MM is wrong, I’ve looked at a selection of criticisms made of MM, and frankly the criticisms are a joke (4.). Plus Sir John Vickers published a paper a year or so ago which devoted a few paragraphs to MM (5). He concluded, far as I can see, that while a few minor criticisms could be made of MM, there is nothing seriously wrong with it.

It’s the Bank of England Financial Policy Committee and other regulators round the world who are wrong. Or put another way, regulators have given way to pressure from banks to make only minor changes to bank capital ratios. But worst of all is the fact that these “asleep on the job” regulators can’t see through the wholly specious “increased bank funding cost” argument used by banks.

1. The BoE FPC say, “Within this model, higher bank capital reduces the likelihood of financial crises which can lead to reductions in GDP.(3)However, the model generates some macroeconomic costs of higher levels of bank capital since it assumes that banks pass through the costs of increased regulatory capital requirements as higher lending spreads. This increases real economy borrowing costs, which reduces the level of investment and therefore output in equilibrium.(4) Therefore, within this model, the net macroeconomic benefits of additional bank capital fall if the capital level increases too much.”
Incidentally, the “model” referred to is a National Institute of Economic and Social Research model.
2. See Bloomberg article by Matthew Klein: “The Best Way to Save Banking is to Kill It”.
3. See Wolf’s Financial Times article “Why bankers are intellectually naked.”
4. See “The Solution is Full Reserve / 100% Reserve Banking” here, under the heading “Flawed criticisms of Modigliani Miller” (section 1.4).
5. “Some Economics of Bank Reform”, Oxford Department of Economics Discussion paper 632.


  1. Is it the case that increasing the reserves a business is required to retain is equivalent to changing its capital structure? I don't think so.

    Capital structure has to do with the source of the funds used in the business - are they debt based (i.e. hard payment obligations) or are they equity based (i.e. you only get paid if there is net profit.

    If you increase reserve requirements on a business you don't change the source of funds it uses, you just force it to have a bigger buffer of assets than it needs in order to remain solvent.

  2. One needs to be careful with the word "reserves". The word has a very specific meaning in the case of banks: it refers to their stock of central bank money. With other businesses the word is much more vague. But that apart, I agree with you.

  3. You are undoubtedly right that attempts to regulate banks by so-called "capital ratios" are a shambles.
    And yes, increasing the "capital" requirement very slightly is almost insignificant.

    However, it is unclear why you object to the BoE's statement that:
    "banks pass through the costs of increased regulatory capital requirements as higher lending spreads. This increases real economy borrowing costs"

    Isn't this the same point as that in in Ralph Musgrave's book page 15:
    "a rise in capital required by banks will result in a rise in returns demanded by shareholders in all corporations (banks included) for the country as a whole. But to repeat, that simply reflects the removal of a subsidy, thus there can be no legitimate objections there".

    Relatedly, or perhaps due to my ignorance, I don't see why the M&M theorem is relevant.

    1. The reason I object to the “banks pass through…” sentence is that I suspect the authors think that because shareholders demand a higher return than depositors, bond-holders, etc, that therefor raising capital ratios will increase TOTAL bank funding costs. That is exactly the fallacy which M&M demolished.

      However, nowhere in the publication (far as I can see) do the authors explicitly say WHY they think raising capital ratios increases funding costs. The reasons seem to be buried in a NIESR model. And when I looked a few minutes ago, the NIESR server was down. Anyway, the authors, with a view to clarity should have spelled out EXACTLY WHY they think that increase in funding costs arises.

      Re the point on my p.15 (actually p.24 I think), I was referring to a rather arcane and probably minor effect (which no one else has mentioned, far as I know). That is that if the supply of willing shareholders vis a vis depositors / bond-holders etc for the country as a whole is inelastic, then requiring banks to be funded by more capital will result in a rise in the return demanded on shares / capital for ALL CORPORATIONS, including banks.


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