That’s how it goes when you prefer to read Ayn Rand

10 August, 2017 at 10:29 | Posted in Economics | 2 Comments

A couple of years ago the former chairman of the Fed, Alan Greenspan, wrote in an article in the Financial Times, speaking of the continually increasing demands for stronger regulation of banks and finance:

Alan Greenspan and Ayn Rand at the White House after Greenspan was sworn in as chairman of Gerald Ford’s Council of Economic Advisers, September 1974Since the devastating Japanese earthquake and, earlier, the global financial tsunami, governments have been pressed to guarantee their populations against virtually all the risks exposed by those extremely low probability events. But should they? Guarantees require the building up of a buffer of idle resources that are not otherwise engaged in the production of goods and services. They are employed only if, and when, the crisis emerges.

The buffer may encompass expensive building materials whose earthquake flexibility is needed for only a minute or two every century, or an extensive stock of vaccines for a feared epidemic that may never occur. Any excess bank equity capital also would constitute a buffer that is not otherwise available to finance productivity-enhancing capital investment.

That is — to say the least — astonishing. Not wanting to take genuine uncertainty or ‘fat tails’ seriously is ominous enough. Is there anything the year 2008 taught us, it is that the ‘tail risks’ are genuinely real and must be included in all financial calculations. But even worse is how someone – who surely ought to have read at least an introductory course in economics – can get the idea that demand for higher capital requirements of banks would be equivalent to building buffers of ‘idle resources.’ The claim is from an economist’s point of view absolute nonsense.

Capital requirements are about how the mix between debt and equity of banks’ balance sheets should look like. It is not a question of something having to be set aside. It is not about liquidity or reserve requirements. Capital requirements are not about pea soup in a jar that we should put on stock to have in a crisis. It’s about how much leverage we should allow banks to have.

Higher capital requirements simply mean that we demand that banks finance a larger portion of their portfolios out of equity and less out of money deposited or loans. There is nothing here about resource use, but about how banks should manage risks. And how they are distributed in an economically efficient manner.

Of course, higher capital requirements mean that banks’ risk taking decrease. It is precisely because of this the requirements have been instituted. We saw in the recent financial crisis how the ‘systemic risk’ shot up when the banks were found to have taken on too great risks. Financial institutions authorized to operate with high leverage generate negative externalities. Of course, we have to — in the light of the financial crisis — ensure that banks operate under less leverage. Higher capital requirements are one way of achieving this.

If the crisis comes and there would be a loss of 1 million USD, and the bank’s own capital is, for example, 5% of the balance sheet, that would force the bank to liquidate assets at a value of 20 million USD to regain the 5% level. Obviously, systems repercussions would be monumental. Higher capital requirements would both reduce the risk of liquidation, and the repercussions would be smaller (20% equity level would, in our example, reduce leverage to 5 million USD).

Suppose the initial balance sheet looks like this:

Loan: 100    Shareholders’ equity: 5
Liabilities: 95

Now if you raise the capital requirement from 5% to 20%, the bank can in principle react in three ways:

A: Assets Liquidation
Loan: 25   Equity: 5
Liabilities: 20

B: Recapitalization
Loan: 100 Shareholders’ equity: 20
Liabilities: 80

C: Assets Expansion
New assets: 12.5
Loans: 100  Shareholders’ equity: 22.5
Liabilities: 90

In both cases B and C it is evident that the higher capital requirements don’t mean that the balance sheet must be reduced. Banks can continue to provide the economy with the necessary loans. Some negative effects on the banks’ ability to perform their basic system functions need not occur because one raises the capital requirements.

This is basics. That a former Federal Reserve chairman does not understand this is, to say the least, disheartening.

But maybe that’s how it goes when you prefer reading Ayn Rand to Keynes or Minsky …

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2 Comments

  1. I am intensely skeptical of the current fashion for macro prudential models of bank regulation and their reliance on totemic capital requirements. The excellent S Randy Waldman explained some of the fundamental problems in an essay on his Interfluidity blog. http://www.interfluidity.com/v2/716.html
    .
    My own expertise in industrial organization leads me to gesture at a different set of points about how to think of the problem of systemic risk and financial and banking regulation. The leverage of a manufacturing firm or a railroad may constrain the behavior of management, but that is because the leverage is an incidental commitment complementing the main source of business value and revenue. For banks or other financial intermediaries, leverage is the main business. The bank’s own nominal risk-taking is not the main event; it is the enabling of risk-taking by non-financial firms and households that poses a systemic risk. When the financial sector begins manufacturing volatility to pad its own profits, instead of fulfilling its proper role as an intermediary doing verification and constraint, it is the whole economy that accumulates “risk” in the form of toxic financial assets and misallocated investment. If banks are causing firms and households to take on too much debt, in large part by practicing and nurturing control frauds, a bit of nominal bank capital will not help when the consequences come.
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    I think we ought to be thinking less about nominal capital requirements in a world dominated by the TBTF giants like Citibank or Deutsche bank and more about economic rents and how modest rents could be created by rules that would enable a more diverse population of individually much smaller, less politically powerful and strategically more specialized intermediary institutions.
    .
    That so little of mainstream “thinking” addresses economic rents or institutional structure is worrisome. It is almost as if mainstream economics takes making the political process ignorant and stupid as its mission.

  2. All three of Greenspan’s examples involve an artificial scarcity of money. Expensive building materials do not mean the materials are scarce; only the knowledge of how best to protect against earthquakes is scarce. We can extract the materials if the building is a good idea, and if guaranteeing safety is a good idea. If Fukushima had been built to withstand a tsunami, would it necessarily have had to be smaller? Would the extra material investment really crowd out other building, because there isn’t enough building materials? Greenspan’s assumption that scarcity of money represents a scarcity of resources is faulty. The real scarcities facing Fukushima were of money and knowledge. Idling a resource is not the real issue.

    Also note that the Fed successfully ended the 2008 financial crisis by signaling that it would provide unlimited liquidity. The Fed created money from thin air, expanding its balance sheet by over 500% (from $800 billion to $4.5 trillion), including the granting of unlimited currency swap lines to the ECB and other major central banks. And the dollar got stronger.


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