Saturday, 7 April 2012

Banks: Reserves sorted. Now lets talk capital

Lorenzo Perrone - Constraint
The debate over reserves is over and I think its pretty clear now that banks are not constrained by their reserves in any system with a floating exchange rate where the central bank is trying to maintain an interest rate. There just isn't anywhere in the system that the central bank can intervene to enforce a constraint on that side of the balance sheet without destroying the payments system, losing control of the policy rate or both.

Even with full reserve entities like Building Societies there are modern financial mechanisms in place that mean they can lend on their capital just like banks, topping up the deposits later as needed.

So there is no meaningful difference between fractional reserve and full reserve entities. The hoops they jump through may be slightly different but the end result is the same - both are constrained by the number of creditworthy borrowers coming through the door at the current price of money, or the regulated ratio of loans to capital buffer. Whichever comes first.

(You'll note that means the 'positive money' crew is likely barking up the wrong tree. It doesn't matter whether the central bank issues excess reserves, or covers the system with an insurance policy.  Unless they close the discount window - and stand the payments and rate chaos that would cause - the banks will still be able to lend up to the regulated ratio of their capital).

Up to now the majority of models and writings mention capital in passing. The constraint is acknowledged, but not really described in depth (certainly not to my satisfaction). So now we need to understand what the capital constraint means and whether the current control mechanism - the ratio of loans to capital - is adequate for the task.

Bank capital represents somebody else's savings. It is a financial investment from the saver's point of view. So in that sense it works very similar to the deposit money multiplier. Some entity has reduced its spending to invest in the bank, and that gives the bank a multiple of that investmetn to lend out. So if the capital ratio requirement is 20%, and there is a preference share issue of £100 then the bank instantly expands its loan capacity by £500.

You'll note there is no geometric progression required here. The capacity expansion is instant.

In addition to this the bank is constantly earning money from the interest it charges. Any amount retained after costs adds to equity every day and similarly expands the capacity of the bank to lend.

And then we move onto the more esoteric capital expansion mechanisms: simplistically third party C borrowing from bank A to invest in capital stock in Bank B - and so on. The result of that arrangement - when aggregated up - is that capital is not constrained by quantity either, but once again by price.

So is there a good description of the capital constraint mechanism anywhere, and have any alternatives to the capital ratio requirement been put forward? Would it be a useful macro control to cap a bank's lending at a fixed amount of loans for example?

What would be the best design for the capital constraints on a bank that would allow us to contain them while still giving them the flexibility to serve business? Your thoughts please.