A popular line of argument blames the lack of bank lending despite the Fed's extended ZIRP policy on the impaired capital position of the banking sector. For example, one of the central tenets of MMT is the thesis that "banks are capital constrained, not reserve constrained". Understandably, commentators extrapolate from the importance of bank capital to argue that banks must be somehow recapitalised if the lending channel is to function properly as Michael Pettis does here.

The capital constraint that is an obvious empirical reality for individual banks' does not imply that bank bailouts are the only way to prevent a collapse of the monetary transmission channel. Although individual banks are capital constrained, the argument that an impairment in capital will induce the bank to turn away profitable lending opportunities assumes that the bank is unable to attract a fresh injection of capital. Again, this is not far from the truth: As I have explained many times on this blog, banks are motivated to minimise capital and given the "liquidity" support extended to them by the central bank during the crisis, they are incentivised to turn away offers for recapitalisation and instead slowly recapitalise by borrowing from the central bank and lending out to low-risk ventures such as T-Bonds or AAA Bonds. This of course means that they are able to avoid injecting new capital unless forced to do so by their regulator. Potential investors know of this incentive structure facing the bank and are wary of offering new equity. Moreover, injecting new capital into existing banks can be a riskier proposition than capitalising a new bank due to the opacity of bank balance sheets.

So the bank capital "limitation" that faces individual banks is real, in no small part due to the incestuous nature of their relationship with the central bank. But does this imply that the banking sector as a whole is capital constrained? The financial intermediation channel as a whole is capital constrained only if there is no entry of new firms into the banking sector despite the presence of profitable lending opportunities. Again this is empirically true but I would argue that changing this empirical reality is critical if we want to achieve a resilient financial system. The opacity of bank balance sheets means that even in the most perfectly competitive of markets, it is unlikely that old banks will find willing new investors when dramatic financial crises hit. However, investors most certainly can and should start up new unimpaired financial intermediary firms if the opportunity is profitable enough.

The onerous regulations and the time required to set up a new bank clearly discourage new entry - see for example the experience of potential new banks in the UK here. But even if we accelerate the regulatory approval process, the fundamental driver that discourages the entry of startup new banks is the Too-Big-To-Fail(TBTF) subsidy extended to the large incumbent banks that ensures that startup banks are forced to operate with significantly higher funding costs than the TBTF banks. This may be the most damaging aspect of TBTF - not only does it discriminate against existing small banks, it discourages new entry into the sector thus crippling the monetary transmission mechanism via the bank capital constraint.

Comments

Rajiv Sethi

Very interesting post... links up with your earlier comments on Richard Fisher's speech. But do you endorse his views on limiting bank size, or do you think that failures should be allowed regardless of size?

admin

I prefer that failures be allowed and losses imposed on creditors but obviously the systemic implications of this scare the living daylights out of the Fed. I'd rather spend a trillion dollars mitigating the impact of the systemic fallout on the common man than sustain the bad incentives which will ultimately cost us a lot more. Breaking up the big banks is not an unreasonable "second best" idea but I'm not as convinced as he is that this will really solve the problem of homogeneity amongst banks. Maybe some sort of punitive taxation based on size could level the playing field. Anyway, this post is just one small point in a broader theme I'm increasingly convinced about - that all our macroeconomic policy is being stymied by real micro blockages and problems with the underlying incentive/competitive structure in the economy, esp. in the banking sector.

Rajiv Sethi

Yes, I'm with you on this. It seems to me that limiting bank size is a very clumsy way to deal with the problem and (as you said) not necessarily effective in any case. It would have been better for the Fed to have lent freely and massively against good collateral, protecting firms facing short term liquidity problems but letting the insolvent ones fail, regardless of size. The counterargument is that we would have had another Great Depression but I'm skeptical.

David Merkel

I wrote a couple of pieces on this. Here is one of them: http://alephblog.com/2009/01/10/a-new-goal-for-tarp-money-create-mutual-banks/

admin

Rajiv - Yes, probably the "Great Depression" for bankers but unlikely for the rest of the economy!

admin

David - Thanks! I hadn't read that post from you and yes, that would have been a better use of TARP money.

JackW

I read Pettis's very good article (thanks for the tip) and am not sure why you say that he is arguing that banks must be recapitalised if the lending channel is to function properly. My reading is that he says all the major banking systems are in trouble and that since after a banking crisis the banks are always cleaned up by forcing the household sector to pay, this will limit future consumption growth. Am I not understanding something?

admin

Jack - Given the current barriers to entry, I don't dispute Pettis' analysis in terms of its empirical accuracy. But if there is free entry and exit, there is no need for the household sector to pay anything at all because the banks don't need to be cleaned up. The incumbent banks go bust and new banks take their place. To put it differently, the total amount of equity capital potentially available to any sector (including banking) is not limited if entry is free. Of course if there are no borrowers worth lending to, capital that actually enters banking may shrink anyway but that is no bad thing.

JKH

The purpose of capital is to absorb unexpected losses due to risk. Therefore, capital is a required structure of finance for risk taking. And therefore, capital is a constraint on risk taking. Almost all lending is a form of risk taking (e.g. lending to fiat currency issuers excluded, although even lending to a fiat currency issuer might include some interest rate risk which in turn requires capital, depending on the pricing structure of the deal). So capital is a constraint on lending, not because it is lending per se, but because it is a form of risk taking. At first, banks impose their own standards for capitalization. Then the regulators get involved, and their standards become superimposed. The fact is that some banks, given regulatory constraints, then proceed to self-impose standards that are even more rigorous than regulatory minimums. E.g. this was the case through the crisis for all major Canadian banks. Capital constraints translate in terms of both the quantum and pricing of risk, and the quantum and pricing of capital. These things must match up properly in order for banks to actually take on risk that they are considering in the proposal stage. You point out very correctly (more or less) that the concept of “hurdle” is critical in the decision to take on risk. So the constraint works there at the level of allocation of available capital. By definition, available capital is excess capital until it is deployed to take risk, whereupon it becomes utilized capital. In addition to the constraint in terms of meeting the hurdle to utilize available capital, there is also the constraint in terms of the availability of excess capital per se – i.e. whether an individual bank in a position where it has the excess capital to even make the allocation choice for new projects. Finally, the word “constraint” can apply in the aspect of a bank’s ability to generate new capital internally or externally. The last two usages of the constraint idea were particularly impinging during the financial crisis. So “constraint” is a multi-nuanced word when used to characterize bank capital. However, I see little value in distinguishing the meaning of capital constraint in any truly fundamental way as it applies to the banking system versus an individual bank. And this is where it gets very interesting from an MMT perspective – because the appropriate and very meaningful distinction between systemic and specific dimensions when talking constraints is in the aspect of bank reserves rather than bank capital. The economics profession for the most part is apparently cursed by a failure to understand the difference in these two distinctions – i.e. the importance of the fallacy of composition in understanding the reserve system, versus its lesser role in understanding the nature of bank capital constraints, in my view. (also submitted at winterspeak's)

JKH

in the above, "You point out very correctly" related to the winterspeak discussion