Thursday, 26 March 2015

If bank capital is expensive, how come bond mutual funds survive?

Bank regulators and politicians are suckers: they fall for every sob story spun to them by banks. In the case of politicians, an additional motive to fall for the sob stories is of course the cash in brown envelopes offered to politicians by banks - or perhaps the phrase “cash in brown envelopes” is impolite. Let’s re-phrase that and call it “contributions to election expenses”.

Anyway, one of the main sob stories is that bank capital ratios cannot be raised too much because bank capital is allegedly a more expensive way of funding banks than debt (i.e. deposits or bonds).

Modigliani Miller.

The most na├»ve reason for thinking that capital is expensive is the fact that bank shareholders demand a higher return than depositors or bond holders. That’s because when a bank is in trouble, it’s shareholders who lose out before debt holders.

However, that does not prove that if capital ratios are raised, that the TOTAL cost of funding a bank rises. Reason is that the total risk involved in running a bank is determined by how risky its loans and investments are, not by how it is funded. E.g. a bank which concentrates on NINJA mortgages is riskier than one that concentrates on standard mortgages.

Thus if a bank is funded by more capital and less debt, that has no effect on the total risk the bank runs. I.e. given a rise in the capital ratio, all that happens is that return demanded PER SHAREHOLDER or PER SHARE will fall, leaving the TOTAL return demanded by shareholders and debt-holders unchanged, as explained by the two economics Nobel laureates Modigliani and Miller.

Bond mutual funds.

Now a mutual fund (“unit trust” in the UK) which invests just in bonds (and there are plenty of funds which do that), comes to very much the same thing as a bank which is funded just by shareholders.

The stakes obtained in those funds by those who buy into such funds are not actually CALLED SHARES. But that’s what those stakes are, to all intents and purposes. For example the value of those stakes rise and fall in line with the value of the underlying assets just as shares tend to. Plus the money put into those funds is effectively loaned to a variety of corporations and perhaps cities or local or national governments (depending on what the fund specialises in). And what do you know? That’s what banks do: lend to a variety of borrowers.

So for those who want to claim that bank capital is expensive, I have a question: how do bond mutual funds survive, given that they amount pretty much to banks funded just by capital?

Capital ratios.

What makes this whole argument very silly is the MINUTE increases in bank capital proposed by for example the Basel regulators and the UK’s Independent Commission on Banking. According to Martin Wolf (chief economics commentator at the Financial Times), the ICB proposed increasing that ratio from a measly 3% to a measly 4%. And the ICB spend hundreds of hours scratching their heads over whether to raise the ratio any further.

Well the “3% - 4%” argument is a COMPLETE IRRELEVANCE given that it can well be argued that a 100% ratio (i.e. having banks funded JUST BY shares) would not raise bank funding costs.

Or as an alternative, you might prefer the 25% or so ratio advocated by Martin Wolf and Anat Admati of Stanford. But certainly the “3%-4%” argument is a joke.

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