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Higher Required Capital Won't Crimp Bank Lending?

August 05, 2010
Thomas Brown

Thomas Brown

4 followers
The Wall Street Journal’s David Enrich seemed surprisingly credulous yesterday when he reported that several recent academic studies conclude that requiring banks to hold higher capital levels—which is precisely what the federal government is doing--won’t reduce the availability of credit.

On its face, that conclusion is crazy. If you raise the amount of capital a bank has to hold, then, by definition, that bank will carry fewer assets (read: loans) on its balance sheet. Which is to say, it will lend less. That’s how the arithmetic works. There’s no way around it.

What’s more, if a bank that boosts its capital wants to maintain its profitability (and, as a bank investor, I’m in favor of that) it’s going to have to raise the interest rate it charges borrowers. Again, it’s basic arithmetic.

So raising capital levels will reduce the availability of credit and make credit more expensive. Yet the studies’ authors want us to believe otherwise. One of them, Douglas Elliott of the Brookings institution, tells Enrich that a 400-basis-point increase in a capital would raise lending costs by only 20 basis points. Really?

Actually, not. If you go through Elliott’s study in detail, you’ll see that that hypothetical 20-bp rate rise is accompanied by some highly iffy assumptions. Among other things, “administrative costs” are supposed to fall by 10 basis points (good luck with that), while “other benefits,” whatever those are, are supposed to improve by 10 bp. And the bank’s debt costs are supposed to fall by 20 basis points, even though (as Elliott himself notes) bank liabilities are mainly deposits that are guaranteed by the federal government and therefore are already as cheap as they’re likely to get.

All of which is a long way of saying that Elliott seems to have made some unrealistic tweaks to his assumptions to arrive at his conclusion that boosting capital levels would raise borrowing costs by 20 basis points. (Actually, under a more realistic set of assumptions, Elliott concludes that lending rates would rise by a not-insubstantial 45 basis points.)

Academics and regulators seem to desperately want to believe that forcing banks to boost their capital won’t crimp bank lending. Sheila Bair tells Enrich, for example, that banks are using “scare tactics” when they point out the obvious. In this, as in so much else, Bair is simply wrong. And these studies that purport to prove that two plus two equals five are wrong, as well. If you force a bank to raise capital, lending goes down and loans become more expensive. There’s no way around it.

What do you think? Let me know!

Thomas Brown

http://www.bankstocks.com/


Rating: 1.7/5 (3 votes)

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