Wednesday, 25 November 2015

Carney proposes temporary bank capital increases.


Absolute genius.
 

The opening sentence of this Financial Times article reads, “Mark Carney signalled that the Bank of England stands ready to increase capital requirements for banks temporarily as a way to curb excessive lending while interest rates stay low.”

First, what’s the point of a cut in interest rates (designed to encourage lending) and then negating that with higher capital requirements? Bit like driving a car with the accelerator and brake pedal permanently on the floor.

Second, it’s a popular myth that because bank shareholders demand a higher return than debt holders, that therefore increasing the capital ratio will increase the cost of funding the bank (or indeed any corporation).  Shareholders demand a higher return because in the event of trouble, their hair gets cut first. However if the amount of equity is say doubled, then the risk PER SHARE his halved: thus there’s no effect on the total cost of funding the bank.

In fact taking that to the extreme, and comparing a bank funded just by equity as compared to one funded just by debt, in theory there’d be no difference in funding costs because the chance of funders losing X% of their stakes is exactly the same in both cases.

To illustrate, if it suddenly transpires that the assets of a bank are worth half their book value, then in the case of the equity funded bank, the shares will drop to half their initial value (on the simplifying assumption that the value of shares is determined just by the value of the underlying assets and not by the bank’s perceived prospects).

As to the debt funded bank, the bank will be wound up and the assets sold off. Debt holders will get back – wait for it – half their initial stake in the bank!


The pre-crisis house bubble.

Third, the pre-2007/8 crisis bubble took place DESPITE interest rates that were higher than today’s. Thus there is not much reason to suppose that low interest rates have much effect on bubbles.

Of course there’s an appealing logic in the idea that low rates cause bubbles. It runs something like, “Low rates induce people to borrow more, which pushes up house prices”.

Well that “borrow more when rates are low” phenomenon is entirely predictable and doesn’t constitute a bubble. A bubble is a feed back loop which can take off at any time. It runs something like this. House prices rise, which induces everyone to think they will rise further, which induces everyone to invest more in housing, which causes house prices to rise even further.

That can happen regardless of whether interest rates are high or low. To repeat, it actually did happen just prior to 2007.

Fourth, bank capital should be at a level that means there is a vanishingly small possibility of taxpayers having to rescue banks. Reason is that any such rescue constitutes a subsidy of banks.

Now if bank capital is actually at that level or above it, then raising bank capital further will not bring additional safety. On the other hand if bank capital is sufficiently low that THERE IS a possibility of banks being rescued, then bank capital should sod*ing well be raised anyway.

Fifth, if low rates do in fact promote bubbles, that’s just extra support for the idea pushed by Positive Money and others (me included) that interest rate adjustments are not a clever way of adjusting demand. Interest rate changes only influence the behavior of borrowers and lenders. A significant proportion of households do not have mortgages, nor do they lend significant amounts. Same goes for some employers. Why should the latter lot of households and employers be excluded when stimulus is the order of the day?

All in all, Carney’s idea is a litany of false logic. Though to be fair, he is trapped in a system in which false logic reigns supreme, so it’s not entirely his fault. 

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