Today I have been reading up on the new proposals from the Basel Committee to tighten the capital requirements and introduce new liquidity rules as a further strengthening of the regulatory framework on banks. There is a mountain of literature to get through on all of this. But I came across two divergent views on the new proposals. Some commentators are arguing that these requirements hinder the banks’ ability to create credit and hence put a regulative drag on growth. If they are tightened then growth will be lower than otherwise. The other view expressed by a noted “progressive” economist disputed this view but then got confused in a mainstream macroeconomics labyrinth. It brought home the fact that people often confuse capital adequacy requirements and reserve requirements.
We should start by making sure we don’t get into the confusion that seem to commonplace in this sort of debate. There is a fundamental difference between capital adequacy requirements on banks in a regulatory framework and reserve requirements. The two sorts of rules are quite distinct but are often conflated by those who do not know how the monetary system operates.
In this blog – Bond markets require larger budget deficits – I outlined the system of banking supervision based on capital adequacy requirements which has been developed by the Bank of International Settlements.
In that blog I go through the system of regulation implemented by the BIS starting with Basel I and now moving into Basel III. I described how this system of bank regulation aims to establish a transparent framework on how banks (and other deposit-taking institutions) manage their capital.
The general approach of the Basel framework is to express a bank’s capital relative to its risk. Capital is divided into Tier I Capital (contributed equity plus retained earnings) and Tier II Capital (preferred shares and a proportion of subordinated debt).
The risk is expressed in terms of risk-weighted assets, which range from cash and government bonds (zero weighted) to 100 per cent weighted riskier loans etc.
Capital requirements place a limit on the leverage ratios that banks can run with and thus attempt to limit risk-taking. They also constrain the size of the banks because capital is costly. Finally, they reduce the public-private partnership ratio inherent in any banking system where governments will bail out the depositors in event of failure. The higher the capital held against its assets the more the shareholders are exposed to bank failure.
Different nations compute bank capital differently. For example, while the US implemented Basel i rules and signed onto Basel II in 2004, they did enforce the rules (which changed the risk-weightings) and the banks failed to comply. This was a major regulatory oversight.
Basel III will introduce the liquidity coverage ratio as a response to the global crisis and the BIS is proposing that all international banks hold unencumbered assets equal to all the liabilities that are coming due within the next 30 days. This buffer is designed to offset any bank runs and thus preserve overall liquidity and reduce the need for government bailouts.
The other major change is in Basel III, is that banks would have to maintain a “net stable funding ratio” of 100 percent. This means that they would have to have an amount of longer-term loans or deposits equal to their financing needs for 12 months, including off-balance-sheet commitments and anticipated securitizations.
The main motivation of the capital adequacy regulations was to limit the bank’s capacity to originate loans and providing incentives for them to increase their capital. The flaw in the approach was that the risk-weighted ratio could be increased by increasing capital (the numerator) or reducing assets (denominator). The latter could be achieved by balance sheet restructuring which is exactly what banks did.
The resort to capital arbitrage (for example, securitisations) was one major way banks could get around the capital adequacy rules. Securitisation refers to a process where a bank originates mortgage loans, pools them and takes them off their balance sheets by selling them to a third party (a so-called Special Purpose Vehicle). The SPV then markets the assets to investors as fixed-income securities and the cash proceeds go back to the bank (after fees are deducted).
By shifting the loans off their balance sheets (that is, pushing them to the SPV) the bank can increase its capital ratio but the overall leverage in the system is unchanged. Further, the risk-weightings are in broad bands and the bank may have sold high quality assets (at the top of the band) and retained poorer quality (at the bottom of the 100 per cent band). In simple ratio terms, the bank looks better but in terms of risk it is more exposed to failure.
The new Basel proposals are designed to stop this sort of evasion.
Most advanced nations have fully implemented Basel I and II which define lending limits as a multiple of a bank’s capital. So the fundamental principle is that bank lending is capital constrained under this regulatory framework despite the devious ways banks have been able to evade the rules or the laxity of enforcement of the rules in certain nations.
Reserve requirements place not such limit on lending for reasons I have explained often. Commercial banks hold reserve accounts at the central bank for the sole purpose of facilitating the payments system (clearing house). Many countries have no reserve requirements other than the accounts must not be in the red on a sustained basis. The US is currently considering eliminating the positive requirements.
Reserve requirements are an artefact of the old gold standard and are irrelevant in the current monetary system. They do not reduce bank risk nor do they comprise a buffer that can be drawn on when there is a run on a bank.
To understand why reserve requirements do no constrain lending you have to understand how a bank operates. Banks seek to attract credit-worthy customers to which they can loan funds to and thereby make profit. What constitutes credit-worthiness varies over the business cycle and so lending standards become more lax at boom times as banks chase market share (this is one of Minsky’s drivers).
These loans are made independent of the banks’ reserve positions. Depending on the way the central bank accounts for commercial bank reserves, the latter will then seek funds to ensure they have the required reserves in the relevant accounting period. They can borrow from each other in the interbank market but if the system overall is short of reserves these horizontal transactions will not add the required reserves.
In these cases, the bank will sell bonds back to the central bank or borrow outright through the device called the “discount window”. There is typically a penalty for using this source of funds. At the individual bank level, certainly the “price of reserves” may play some role in the credit department’s decision to loan funds. But the reserve position per se will not matter. So as long as the margin between the return on the loan and the rate they would have to borrow from the central bank through the discount window is sufficient, the bank will lend.
So the idea that reserve balances are required initially to “finance” bank balance sheet expansion via rising excess reserves is inapplicable. A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.
The major insight is that any balance sheet expansion which leaves a bank short of the required reserves may affect the return it can expect on the loan as a consequence of the “penalty” rate the central bank might exact through the discount window. But it will never impede the bank’s capacity to effect the loan in the first place.
Please read my blog – Money multiplier and other myths – Building bank reserves will not expand credit – Building bank reserves is not inflationary and Oh no … Bernanke is loose and those greenbacks are everywhere – for more discussion on this issue.
However, capital requirements do place a limit on the expansion of a commercial bank’s balance sheet at any point in time. This primer is good on capital requirements although I do not agree with all that is said.
That was the motivation behind the Basel Committee’s regulatory framework (Basel I and Basel II and soon Basel III). It was to actually reduce the risk of banking and hence create a more stable financial system. The more stable investment climate (for productive capital) would translate into higher rates of economic growth.
It is clear that the bank meltdowns that precipitated the current real crisis which quickly spilled over into the real economy with massive consequences for income generation and welfare. The real economy around the world will take years to recover from the damage that the recession has caused.
In some countries, for example, Latvia, GDP has shrunk by around 20 per cent and forecasts are that it will continue to deteriorate by some 4-5 per cent in 2010 before it shows any sign of recovery. That is one-fifth of the real economy has gone because of the financial excesses of the banking system.
So I think it is difficult to argue that any reforms that reduce the risk of the meltdowns in the future will not deliver greater economic benefits.
But one Andrew Ross Sorkin in his New York Times column last week (March 29, 2010) entitled – The Issue of Liquidity Bubbles Up – was arguing that any move to increase capital requirements for banks in the US would stifle economic prosperity.
He recounts a conversation last week with one US Treasury Secretary Geithner about increased capital requirements and their likely impact on US banks. He says:
The answer to Mr. Geithner’s question will have a huge impact on Wall Street — specifically, how much money banks are required to keep in their rainy-day accounts. That matters because the more banks hold onto, the less they can lend to growing businesses … Of course, protecting against even infrequent crises probably means forcing banks to keep a lot of cash on hand in case their bets go bad. But that would come at the expense of economic growth as banks would make fewer loans.
Mr. Geithner insists that if there is one change that needs to be made to the banking system to protect it against another high-stakes bank run like the one that claimed the life of Lehman Brothers, increasing capital requirements is it.
So Sorkin is correct in arguing that increased capital requirements will change the capacity of banks to lend. After all, we have to understand that bank lending is capital constrained rather than reserve constrained.
But I think that he is wrong to assume this will reduce economic growth. There is a large literature that has attempted to examine this question since the introduction of the Basel regulatory framework. There is no clear consensus emerging from that literature in part because banks have been able to skirt round some of the rules via capital arbitrage.
There is limited but inconclusive evidence that banks do substitute towards the riskier assets in the weighting class which increases the riskiness of the banks’ overall portfolios.
There is fairly sound evidence “that banks respond to capital ratio pressures in the manner they believe to be most cost effective” over the business cycle and that “(r)aising new capital or boosting retained earnings may be easier in booms whereas cutting back loan books may be more cost effective in economic troughs” (Source: BIS).
This is also consistent with the view that capital adequacy is usually most challenged during times when the economy is performing poorly and demand for credit is low anyway. So it is hard to argue that the credit is being constrained by the capital requirements. They both are being impinged by the parlous state of aggregate demand.
The BIS paper noted above also asks whether “fixed minimum capital requirements create credit crunches affecting the real economy”. The conclude after examining the extant literature that:
It is likely to be the case that in some periods banks in a particular country may find it difficult to maintain the fixed minimum capital requirements and therefore may be forced to cut back lending. It would in fact be strange if fixed minimum capital requirements did not bite in some periods, thereby constraining the banks, given that the purpose of bank requirements is to limit the amount of risk that can be taken relative to capital …
One difficulty in looking at this question is that periods in which banks are severely capital constrained are likely to be those when they are making large write-offs or specific provisions (reducing capital), and in such periods it is also possible that loan demand will be weak. It is also possible that banks may cut back lending, not because of capital constraints, but because of concerns about lending to particular risky sectors.
But to associate this with declining output you would have to say that “any shortfall in bank lending was not fully made up through lending by other intermediaries or by access to securities markets”. The evidence here is mixed although small companies typically suffer more because they rely more on bank lending.
The BIS also note that there is a “link between minimum capital requirements for banks and financial stability and thence output” – the point I made earlier. They say:
Capital requirements for banks attempt to limit excessive risk-taking relative to capital, thereby reducing the likelihood of failures. If they are successful in this, the requirements could, overall, have a positive effect on output.
So tighter capital requirements may limit some credit expansion but provide the conditions for more durable growth cycles by avoiding the speculative bubbles.
Further, from a Modern Monetary Theory (MMT) perspective, there should be no relationship between growth overall and the limiting of private credit. If the increased capital requirements stifle private credit access then there is more space for public goods production and public infrastructure provision.
So lets repeat: bank lending is capital constrained not reserve constrained. Fundamental point that comes out of an understanding of how the monetary system works.
I was then surprised to read the following day (March 30, 2010), so-called “progressive” US commentator Dean Baker attacking Sorkin with this – Sorkin is Wrong: There Is No Tradeoff Between Growth and Bank Capital Requirements.
Hmm, I was expecting to read the progressive line that I outlined above that perhaps capital requirements by making the system more stable allow the economy to enjoy sustainable growth without the huge damaging booms and busts. So averaged over a long cycle the impact of the capital requirements would be positive.
I was disappointed.
This is what Baker said about Sorkin:
NYT columnist Andrew Ross Sorkin warned readers that higher bank capital requirements, intended to ensure safety: “would come at the expense of economic growth as banks would make fewer loans. This is not true.
The Federal Reserve Board decides on the level of reserves that it wants to pump into the financial system based on the level of economic activity. If economic activity is too slow, it can increase the volume of loans available to banks by putting more reserves into the system. Contrary to what Sorkin asserts, it is not necessary for the banks to raise their leverage of the same amount of reserves in order to generate more loans for businesses.
Oh dear. How do you think Dean would go in our weekly quiz? Not too well I think!
In the first paragraph Sorkin was referring to capital requirements. Then Dean introduces reserve requirements in the second paragraph. A basic no-no.
But even worse, is his conceptualisation that the central bank can influence the capacity of banks to expand credit by adding more reserves into the system. Basic error.
If “economic activity is too slow” then the central bank can do very little to expand private credit other than to cut interest rates. The availability of reserves will not increase bank lending. This is the old fashioned money multiplier version of banking where there the “money supply” is some multiple of the monetary base (provided by the central bank).
By manipulating this “multiple” the mainstream economists claim, erroneously, that the central bank can control the money supply. Absolutely wrong. So I am amazed that our so-called “progressive” Dr Baker is perpetuating this tripe. Perhaps it is a statement of how bad things are in the US when this nonsense represents progressive commentary.
The obvious way a bank which is sitting on its requirement capital ratio can expand its capacity to lend is to increase its capital – which is exactly what the framework is designed to induce.
Back to Sorkin for a moment. Later in his article he discusses the tension between the banks and the regulators. The former complaining that any limitations on their leverage ratios reduces their profitability. Yes. So what?
He quotes the now totally discredited Alan Greenspan:
A bank, or any financial intermediary, requires significant leverage to be competitive …. Without adequate leverage, markets do not provide a rate of return on financial assets high enough to attract capital to that activity. Yet at too great a degree of leverage, bank solvency is at risk.
While this is correct, it makes a good (unintentional) case for public banking. Over what period do we compute the rate of return? What do we include in this calculation?
If we were to include the massive losses and public bailouts that were required to prevent the entire world financial system from collapsing then the risk-weighted returns would be negative by a long way. A public banking system can deliver financial stability and durable returns (social) with much less risk overall.
But overall, it is sensible to regulate private banks via the asset side of the balance sheet and that is the strategy employed by the capital requirements frameowrk. It is also clear that higher capital requirements and more attention to “off-balance” sheet activity is now necessary.
In a system where the capital requirements are too low, the public exposure to bank failure is that much higher and the moral hazards are high. While the best option is to nationalise the banking system and make it 100 per cent focused on public purpose, the more realistic case is to ensure private banks have adequate buffers to insulate the system against panic.
That will reduce profitability (narrowly defined) but enhance social returns.
The other angle is that private investors would probably accept lower returns if there were tighter capital requirements because their risk exposure is lower. However, total costs to the sector rise when capital requirements rise.
It is amazing that notable progressive commentators are still working within orthodox frameworks and perpetuating basic errors about the way the monetary system operates. It diminishes our side of the debate.
So Dean – if you are unsure – keep your typing hands still, please! If you think you know what you are talking about here – then please go back to the basics and get up to speed on how the system you are proclaiming expertise about actually works.
That is enough for today!