Banks 'capital' requirements. What's the beef?

By Ann Pettifor

There's a lot of nonsense spoken about banks' capital requirements. Bank lobbyists are fond of the threatening the rest of us that if they are expected to"hold" more capital this will restrict the ability of bankers to lend into the real economy. This supposed constraint on bank lending will, they argue, hurt 'economic growth' . (Robert Peston puts the bankers' case most lucidly in his latest post - Who can boss the banks?)

Most of this is deliberate obfuscation by bankers, intended to ward off regulation, and maintain the status quo: namely, a systemically risky, too-big-to fail banking system, forever shored up by taxpayer guarantees and bailouts.

But sadly nonsense about banks' 'capital requirements' is parroted not just by bank lobbyists, but also by economists, policy-makers and regulators - for three reasons.

First, because there is very little coherent understanding amongst orthodox economists of how the monetary system actually operates. Most neoliberal economists believe (sic) that banking is fundamentally a form of barter, with bankers acting as intermediaries between lenders and borrowers. (For more on neoliberal misconceptions read: The power to create money 'out of thin air' ).

Very few members of the economics profession understand that private banks create money or credit out of thin air: or ex nihilo, to use the economic term. In other words, that bankers do not need 'savings' or 'deposits' or 'capital' in order to lend money into the real economy. All they need is a computer keyboard; an account into which to transfer money; collateral; and a promise (contract) from the borrower that the loan will be repaid at an agreed rate of interest over a fixed period of time.

Neoliberal economists do not understand that private banks have been creating money ex-nihilo (or endogenously since before the founding of the Bank of England in 1694. As Cullen Roche correctly argues:

"Banks create loans independent of government constraint (outside of the regulatory framework)....(They) make loans independent of their reserve position with the government. So the textbook money multiplier model where banks lend deposits is in fact wrong." (Understanding the Modern Monetary System by Cullen Roche at Pragmatic Capitalism.)

Of course private banks do face constraints in making private loans. The first constraint is their own solvency. Mervyn King mentioned recently and correctly that

 "heightened uncertainty about the solvency of banks has led to a reduction in the supply of credit."

Second, there is the small matter of the creditworthiness of borrowers. Thanks to austerity policies the UK & EZ economy is shrinking, incomes are falling, and there is no guarantee that borrowers will be able to generate the income needed to repay bank debts.

Third, there is the deep reluctance of a heavily indebted household and corporate sector - to borrow. (For more on corporate debt see the FT's Lex here: Corporate leverage: in the midst of debt. 13 March, 2013).

While the above are all real constraints - the provision of capital for lending is no constraint at all.

The second reason that both you and I, but also regulators and policy-makers are confused about capital requirements, is that bank lobbyists deliberately confuse lending and borrowing. They imply that banks need capital in order to lend. This is just not true, as noted above.

However, banks do need what they call 'capital' for another reason: in order to borrow. And banks love to borrow, because borrowing  to acquire an asset that might increase in value, enables bankers to leverage, potentially, massive gains. Just as you and I might be able to leverage capital gains if we take out a mortgage to buy e.g. a property whose price rises, while the initial deposit required by the bank remains a small percentage of the rising value of the property.

But I am getting ahead of myself. This stuff that banks need in order to borrow and leverage capital gains is what you, or any corporation would call 'equity' - as Anat Admati and Maratin Hellwig explain in their excellent new book: The Bankers' New Clothes.

When you put down a deposit of say 10% on your mortgage to buy a property, you are investing your own equity in that property. That equity is not capital - either for individuals, households or corporations. It is equity. And you never 'hold' equity.

However equity is what bankers call capital. And when they squeal about capital requirements it's because they are giving the impression that they're expected to 'hold' more capital. They are not. They are expected to inject more of their own equity into the asset they have purchased by borrowing. 

Bankers love to borrow - especially for speculation. Borrowing for speculation creates leverage and magnifies risks. Speculation - with borrowed money - is a quick and dirty way of making massive capital gains. These gains are much higher than the gains made from lending for sound investment in productive and income-generating economic activity.

High levels of borrowing relative to low levels of equity can magnify capital gains. Those capital gains are diminished if bankers have to increase their equity relative to their borrowing.

However, high levels of borrowing hinged on low levels of equity are risky, and can magnify losses - massively and systemically.  These are the risks that private bankers expect taxpayers to face and bear.

So when banks squeal about 'capital requirements' - they are really squealing about any attempt by regulators to limit their ability to borrow recklessly and with little of their own equity.

Not that regulators are trying to do that.

Like ships that pass in the night, bankers and regulators speak at cross purposes.

For when e.g. Basel regulators drone on about 'capital requirements' - they're invariably talking about ensuring that banks hold a 'fractional reserve' of capital against their lending. 

Both these conversations are confusing. One, that of the regulators, because of a profound misunderstanding of the nature of private bank credit creation, and a false belief in 'fractional reserve banking'.  The other conversation - led by the bankers -  is designed to confuse.

One final thought on 'capital requirements': before 1988, there were no requirements on private banks to hold 'capital', as Bernard Vallageas points out in Basel III and the Strengthening of Capital Requirement.   Yet, despite the fact that the banks did not 'hold capital' - there were no financial crises between 1945 and the 1970s.  Vallageas notes that:

"curiously the adoption of capital requirements (took place) at the same time as the liberalisation of the financial system, and yet, despite their adoption, they did not prevent financial crises, particularly the major 2007-9 crisis."

Let there be a lesson to regulators in that.