Friday, September 17, 2010

The Fatal Flaw is Economists

Simon Johnson points to what he thinks is the fatal flaw in Basel III:
The heart of the substantive discussion regards whether tightening “capital requirements” – the buffers against losses that banks are required to hold – will have a negative impact on the economy. The banks insist that requiring them to hold more capital would slow lending and therefore slow the real economy. The global banks’ Institute for International Finance issued a paper in June that insisted on this point, but there is really no substance to their claims.
I would argue that the fatal flaw is that economists don't understand how banks work, and therefore don't understand the role of capital requirements, or what capital fundamentally is.

Higher capital requirements absolutely limit what banks can lend. Short term, they do this by creating a hard limit to the quantity of loans a bank can extent (ie. capital plays the role economists think reserves play). Long term, a more leveraged bank is more profitable than a less leveraged bank, so higher capital requirements raise the marginal cost of capital, and thus raise the hurdle rate governing the marginal loan.

Tighter lending standards are a good thing, but in the face of an administration that will not increase household aggregate demand, they will also have a negative impact on the economy.

2 Comments:

Blogger Musgrave said...

Agreed.

12:36 AM  
Blogger JKH said...

another good point, w

I'd just add:

An increase in the dollar amount of equity capital, other things equal, reduces the risk to each dollar of equity capital. This is because the reduction in leverage reduces the volatility of the earnings stream.

As a a result of the reduced risk, the required return on equity capital, which is the same thing as the cost of capital, will decline.

There is an analogy in options. A deep in the money option poses less risk to each dollar invested than an at the money option. The expected return declines along with the risk. The lower expected return is reflected in a lower time value for the deep in the money option.

Equity capital is analogous to a call option on assets at a strike price equal to the debt. An increase in required equity capital is equivalent to requiring deeper in the money options as the form of investment.

4:48 AM  

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