Doug Elliott’s flawed arguments against more bank capital.

Doug Elliott describes himself as a “fellow in economic studies” at the Brookings Institution. In this Brookings article (published in March 2015) he argues that while SOME additional bank capital is needed, having banks hold MORE CAPITAL than required by Basel III Accord would be counterproductive.

The basic flaw in the idea that additional capital adds to the cost of funding banks (or indeed any corporation) was explained by two economics Nobel laureates, Franco Modigliani and Merton Miller. And the flaw is thus. Obviously shareholders take a bigger risk than debt holders (i.e. depositors and bond holders). But if the proportion of a bank’s funding that comes from shares is raised, that in no way affects the TOTAL RISK involved in running the bank. That total risk is after all determined just by the nature of the loans and investments made by the bank: they may be high risk (e.g. NINJA mortgages) or low risk. And if the total risk is unchanged, then the total cost of funding the bank remains unchanged when the bank’s capital ratio is raised. I.e. when bank capital is raised, the risk PER SHARE falls, thus the return demanded by shareholders PER SHARE will fall.

Thankfully Elliott at least understands the basics of the Modigliani Miller theory (MM). As he puts it: 

“At first blush, it seems obvious that higher capital levels come with a cost, since shareholders demand higher returns than depositors or bond buyers, to compensate shareholders for taking the most risk. However, Modigliani and Miller, two Nobel-Prize winning economists, showed years ago that the increased safety that comes with more capital reduces the unit cost of all forms of funding in a way that exactly offsets the use of more of the expensive form – in idealized conditions. Some academics have built on this to argue strongly for much higher levels of required capital and gone so far as to claim that it is free from society’s point of view.”


The alleged tax flaw in MM.

However, Elliott claims there are flaws in MM, the biggest of which, apparently, is the fact that the tax treatment of equity and debt is different. (See the para of his just after the above quoted para).

Well there’s a phenomenally simple flaw in that tax point, which is that tax is an ENTIRELY ARTIFICIAL imposition: that is, the AFTER TAX price of any item is not a reflection of that item’s REAL COST. The only exception to that is where a tax is imposed SPECIFICALLY to take account of a cost like the costs of pollution. For example if the tax on fuel for vehicles accurately reflects the environmental costs of burning carbon based fuels, then the after tax cost of such fuel is an accurate measure of the TOTAL cost of that fuel.

To summarise, the “main” objection to MM raised by Doug Elliott is easily demolished.


Elliott’s second criticism of MM.

The above article of Elliott’s refers readers to another of his Brookings Institution articles where he sets out further alleged weaknesses in MM.

Under the heading “The second area of disagreement: government guarantees” Elliott puts the bizarre argument that governments provide explicit and implicit guarantees for debt, thus banks can fund themselves relatively cheaply with debt. Ergo (apparently) debt is an inherently cheaper method of funding banks than equity.

Did you die of laughter at that one? I nearly did.

But just in case you didn’t spot the flaw in that argument, it’s very similar to the above first tax point. That is, government subsidies for X, Y or Z do not reduce the REAL COST of X, Y or Z. When government subsidises something, the APPARENT COST declines, but the REAL COST remains unaltered: all that happens is that taxpayers carry some of the cost. (It’s amazing that I need to explain that elementary point).


Conclusion.

Given the above glaring mistakes in Doug Elliott’s ideas on bank capital, I’ve got better things to do than investigate them any further. Plus as Elliott himself says that the above “tax” point is his MAIN objection to Modigliani Miller, thus I conclude that Elliott needs to go back to the drawing board.

And while Elliott is back at the drawing board, hopefully he will contemplate the fact that the average capital ratio of stock exchange quoted corporations in the UK is 37% according to this Economist article. That’s way above the 5% or so which is typical for a bank. If capital is inherently expensive, one has to wonder what those non-bank corporations think they’re doing.