Friday, 6 March 2015

Bank capital is expensive? LOL.

Those who supply equity to a bank (or indeed ANY corporation) run a bigger risk that those who fund a bank via DEBT (e.g. bonds, or in the case of banks, deposits). Thus equity providers or “shareholders” understandably require a bigger return on capital that bond-holders.

A plausible but in fact flawed conclusion often drawn from the above is that if bank capital is raised, the cost of funding banks will rise. The flaw in that argument is that if the proportion of a bank’s funding that comes from equity is raised at the expense of debt , then the risk per share or per shareholder declines pari passu. Thus altering the latter proportion should have NO EFFECT whatever on the cost of funding banks (as pointed out by Messers Miller and Modigliani).

However the Modigliani Miller theory has been criticised, and one very popular criticism is that the tax treatment of debt is not the same as the tax treatment of equity. For example, the UK’s main official response to the bank crisis, the “Independent Commission on Banking” (ICB) claimed in para A.3.46 that:

“First, the returns on debt are deductible from taxable profits, whereas the returns paid to shareholders are not. More equity therefore means banks pay more tax – a cost to the banks but not, in the first instance, to society.”

Well hopefully you’ve spotted the glaring flaw in that ICB argument. It’s that tax is an ENTIRELY ARTIFICIAL imposition. Tax bears no relation to, and tells us nothing about REAL COSTS, which is what those concerned with bank regulation ought to be concerned with.

To illustrate, if red cars are taxed more heavily than cars painted with a different colour, does that mean that the REAL COST of making or running a red car are higher than the cost of making or running a car with a different colour? Of course not. The average six year old ought to be able to work that out.

Indeed, the ICB sort of admits to the irrelevance of its tax point when it says “More equity therefore means banks pay more tax – a cost to the banks but not, in the first instance, to society.” Yes quite: that is, there’s no “cost to society”.

But what’s that about “in the first instance”? The hint, or the implication is presumably supposed to be that actually THERE IS some sort of cost: in the “second” instance, so to speak.

So what is this mysterious “second instance” cost? Well the ICB doesn’t tell us.

This would be hilarious if the consequences (credit crunches, excess unemployment etc) were not so serious.

Given the high stakes involved here (getting bank regulation right versus making a hash of it), it’s tragic than I need to point to a glaring and simple error like the above, isn't it?


Another “glaring and simple error” comes shortly after the above one (in para A3.50), where the ICB claims that raising bank capital requirements just in the UK would lead to what might be called “regulation evading arbitrage”, that is, banking activity shifting to foreign banks where capital regulations are more lax.

Well the flaw in that argument is that ANY FORM of regulatory imposition on UK banks will tend to lead to the latter form of arbitrage, if other countries do not impose similar improved regulations. Thus the “arbitrage” point is not a weakness SPECIFICALLY in higher bank capital ratios.

As to other alleged weaknesses in the Modigliani Miller theory which the ICB points to, I’ll deal with those hopefully in the near future.

Provisional conclusion.

Messers Modigliani and Miller were right. As a result, bank capital can be raised just as high as we like, even to 100% (as advocated by supporters of full reserve banking). The result will not be to raise the cost of funding banks.

Moreover, where a bank is funded entirely by equity, it’s next to impossible for it to go insolvent, which greatly reduces the chance of, and severity of credit crunches. Thus even a large increase in bank capital DOES INCREASE bank funding costs somewhat, those costs may be insignificant compared to the CATASTROPHIC costs of banking crises like the one we had five or so years ago.

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