Friday, February 22, 2013

Bank capital requires should change the real economy

Slate has a piece on higher banking capital requirements. It's pretty awful, and at one points invokes the Modigliani Miller theorm. Ye gods. An excerpt:
Banks, like other companies, can finance their activities either with debt or with equity. And one common proposal to make the banking system safer is to force banks to rely more on equity-finance and less on debt-finance by increasing the required capital ratio that they have to hold in order to lend. People who own stock in banks hate this idea, since it would involve sharply devaluing the value of their existing shares. But it would clearly make the financial system less vulnerable to runs, so a key question is whether there's any good reason not to do it. The most simplistic answer is "no", that per the Modigliani-Miller Theorem the capital structure of a firm is irrelevant so we could get a free lunch here.
But that's not right. What Modigliani-Miller says is that capital structure is irrelevant in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information none of which applies.
Bank lending is capital constrained, not reserve constrained. So to increase capital requirements will increase the cost of credit by constraining its supply. Modigliani-Miller has little to do with it (MM is not applicable in many circumstances).

If credit contracted, it would lower the price of credit-intensive goods (like housing) and in the current economic climate would probably cause the economy to contract, and further increase unemployment.

To keep that from happening, the reduction in private sector credit needs to be met by larger Government deficits. A government can discipline banks without impacting the real economy only if it is willing to capitalize the private sector directly by running larger deficits.


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