No "Free Lunch" in Banking Regulation

The Bankers' New Clothes:
What's Wrong with Banking and What to Do about It

by Anat Admati & Martin Hellwig.

Publisher: Princeton University Press

MY REVIEW

The ability of financial intermediaries, normally banks, to create money via the device called fractional reserve banking ("FRB") is capable of being both a boon and a bane.

When it works well, savings are mobilised, economic activity is facilitated, incomes increase, wealth accumulates and occasional set-backs are accommodated. It is a magical device without which the modern world could not exist.

In this, it resembles fire. Fire is essential to civilisation but is also extremely destructive when control of it is lost, Similarly,when money creation goes "bad", the consequences can be cataclysmic.

Some say that this is basically unavoidable, and that humanity is condemned to endure such disasters from time to time, just as we must expect another Ice Age sometime, no matter how well we restrain our pollutive natures. That may or may not be so, but I agree with the authors of this book that lessons can be learned and things can be done.

Admati & Hellwig are enthusiasts for the idea that Society can be spared future pain by a more conservative approach to one of the key fractions in FRB, the leverage ratio (often also called the capital ratio). "Whatever else we do, imposing significant restrictions on banks’ borrowing is a simple and highly cost-effective way to reduce risks to the economy without imposing any significant cost on society" is the message of this book, which also gives much space to rebuttal of many contrary arguments. It is a good book, and overall, I think that it makes its case well.

I really wasn't aware, before the book came to my notice, that the issue was so controversial, and I am still a little bemused at the pretty unanimous enthusiasm with which the book has been greeted by some. You can read The Grumpy Economist (No, John Cochrane - and he claims that he is "not really grumpy") and Patrick Honohan - who does admit to some "chafing", mind you - to get the full enthusiastic flavour, or just look at the reviews (including one by Ken Rogoff) summarised by the publishers here. Based on what I have seen myself, the selection appears, unusually for a publisher, to be quite representative. The Amazon ones are here.

My reason for buying the book, though, was because I was astonished by the authors' vehemence (visible in interviews and the Internet) on a point that I (still) think to be incorrect.

I agree that lower bank leverage will bring probably all the benefits that the authors say that it will. Furthermore, I note that they have wisely avoided pinning their colours to the mast of a specific figure, though it's clear that they have roughly 30% in mind (the current average figure is 3%, they say; others put it at nearer 11%). I also tend to side with them in the rebuttals of objections.

My problem is with their insistence that their plan is cost-free for the economy as a whole. I find it odd that there has been so little discussion or challenge of the view that higher bank capital requirements will not actually reduce the flow of loan finance out of the banks. Their approach to this in the book, in interviews and their website is not only wrong, in my view, but perverse.

It is perverse because it requires us to accept that banks' funding structure will have NO effect on banks' activities, whereas Admati & Hellwig spend quite a lot of space describing how the need to attract equity will improve lending standards. Better lending ceteris paribus pretty inevitably means less lending. Admati and Hellwig at different points appear to accept and also to deny this.

While one of the points well made in the book is that (non-bank) users of capital have become too fond of credit and too equity-averse, the authors appear to believe that this preference will frictionlessly pivot on both sides of the balance sheet i.e. depositors will voluntarily become more inclined to take an equity position in the institution where they keep their liquid savings, and borrowers will become more willing to pay in the form of a profit-share to lenders. If anyone doubted that before the Cyprus "bail-in", their fears will not have been assuaged by that fiasco.

I share Arnold Kling's view,

The non-financial sector wants to issue risky, long-term liabilities and to hold riskless, short-term assets. The financial sector accommodates this by doing the reverse.

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Finally, though, I am dismayed by this book, and nearly all of its reviewers, because I see no appreciation of the multiplier effects of capital, and other ratios, on the dynamism of FRB. (Indeed, the words "multiplier", "fractional" and the phrases "fractional reserve banking" and "money-creation" are entirely absent from the text.) Central Banks wishing to dramatically slow down over-heating economies or sectoral markets always could (but very rarely did) increase the minimum ratios.

Raising the capital ratio, which is another way of saying "reducing the leverage ratio" even from 11% to 25% will drastically cut the money supply, even if the appetite for bank equity increases a lot. Raising equity capital may not be as difficult as it once was, but it is still and will always be slower than borrowing from money markets. For Klingian reasons, I doubt that bank balance sheets will, following such a change, end up as big as they were. This will have effects in the real economy.

But, even if this is, improbably, insufficiently optimistic, consider what the position will be going forward with a ratio of 25 instead of 11. Where before the multiplier was 9, now it is 4. For every extra million in deposits, 4 million can be injected as new credit, instead of 9 million. That is a formidably less dynamic monetary environment.

Of course, there will be positive aspects to this: less inflationary pressure and less reckless lending, to name but two benefits well worth having. And as we have painfully re-discovered, excessive dynamism is undesirable. However, as the authors say in another context, "it is impossible to discuss coherently the need for anything without considering its cost". The flow of credit will be reduced, and money creation will be suppressed considerably if we do, as we probably should, adopt Admati & Hellwig's proposal either in whole or in part. Those are significant costs. We should not pretend that they do not arise, even if we think that they are exceeded by the benefits.

Update on Friday, July 12, 2013 at 11:15AM by Fergus O'Rourke

Whoops ! Nearly forgot to mention this by Arnold Kling on the book, in which he adopts, unsurprisingly, a Klingian perspective. My own review was drafted before I discovered this article.

Update on Friday, July 12, 2013 at 11:19AM by Fergus O'Rourke

It's not explicit above, so let me make it so: the authors' repeated claim that they will show, and then that they have shown, that there is no cost to be paid for what they propose is, I say, not sustained in the book, or in the subsequent responses to its critics.