Equity Capital
There is a lot of discussion on the net, good and very accurate discussion, about the reserve requirements, and the current almost absence of same. The Eric deCarbonnel post (hat tip Andre. G. and Mickanomics) has a nice summary of the situation in the US. There is one unfortunate problem though with these discussions - fractional reserve requirements no longer have anything to do with controlling how much money a bank can lend.
What has replaced it, is the regulatory capital requirement. Regulatory or equity capital is a completely separate pile of money that the owners of the bank are required to provide when a bank is started, and maintain at a minimum ratio to their loan book, as the bank is run. The FDIC requires that this be at least $2 million when a bank is founded, plus the anticipated startup costs. The Basel treaties then specify what percentage or leverage ratio the Bank is allowed to maintain between its equity capital and its loan book, and also what kind of financial instruments the Bank can hold the equity capital in.
There are two things then that control the immediate size of the loan book, of any bank in a Basel treaty conforming country. The amount of money it has on deposit (including savings accounts, and term deposits), and the size of its equity or regulatory capital. The fractional reserve requirement, i.e. the difference between the total amount of money it has on deposit, and the total money it has lent out, is relevant only insomuch as it is not allowed to lend out more money than it has on deposit. Just to ensure that complete confusion reigns, the recommended maximum total capital ratio, ie. the leverage ratio of equity capital to amount being loaned, is 10%. The same as the textbook fractional reserve requirement.
This is the 21st century. Weren’t we supposed to have moon bases by now?
It makes some sense, if you only think about the situation at the individual banks. If a bank makes a loan that doesn’t get paid back, and the loan loss can’t be covered out of profits, then equity capital is there, to in theory, prevent the depositors losing the money in their accounts. This is what is being referred to when there is talk about ‘recapitalizing’ the banks. Obviously too, given that this is all that stands between the depositors, national deposit insurance funds, and significant losses in the case of loan defaults, it’s critical that the equity capital be held in extremely safe forms of financial instruments. This is why so much of the discussion and rules around equity capital are framed by the risk of default represented by the underlying securities, and the desirability of keeping that as low as possible. Solutions to the current crisis that involve increasing the equity capital are also being floated.
You can see the mental process path that’s being followed here. If banks take a hit to their equity capital, it reduces their loan capacity. If they take a hit that’s bigger than 10%, they have no equity capital left, and then their depositor’s money is endangered. Do everything possible to prevent that happening, the depositor’s money is now safe, and banking can go back to being boring again.
Unfortunately, system design doesn’t work well, when only the individual entities are considered, and not the interactions between them. Concentrating on the risk of individual bank losses, ignores the larger issues being created by a system whose core set of rules, embodies a relationship and an interdependence between loans and the money supply. Especially, if owing to “financial innovation”, some loan instruments are being allowed to masquerade as money.
The simple answer then, to the question – what is the limit on commercial bank lending? - is that for any given Bank, it is the lesser of the total of their deposits (minus a very small fractional reserve requirement that applies only to Net Transaction accounts), or ten times their equity capital. It follows then, that the instantaneous limit for all the Banks, is simply the sum of their deposits, or equity capital allowance.
But that’s merely the instantaneous limit. It tells us nothing about the way that the system will evolve over time, as loans are made, money is created, loans are repaid and money is destroyed, within the commercial banking sector. Especially within a larger system, that allows debt to be turned into financial instruments, and those instruments to be used as part of the bank’s equity capital.
Or to put it another way, what controls the total amount of equity capital in the system? The old reserve requirement, and its associated commitment to deposit a part of that reserve with the Central Bank, provided the central bank with direct control over the money and loan supplies. What is the equivalent control over the total quantity of equity capital in the system, since it now effectively regulates the money supply? The quick answer, which will be explored in considerably more detail in the next post, is that there isn’t one.
The regulators were concentrating on local risk at the banks. They appear to have overlooked the systemic risks associated with removing control over the money supply.
The hardest problems to correctly diagnose in distributed systems almost invariably involve two or more concurrent bugs interfering with each other. In the banking system at the moment, we have the Asset Backed Security bug, allowing banks to create an arbitrary quantities of loans; and the Equity Capital snafu, which has essentially introduced a slow leak into the money supply. Next post, i’ll run through a detailed example of how they interwork with each other.
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Thanks for the interesting article. Some remarks.
i) Basel
There are different Basel regulations implemented in the US and the rest of the world.
Some publicly available information regarding the Basel II implementation process suggest that the US intended to invent Basel II in January 2009 (which, needless to say, was not done because it would have led to officially insolvent banks). In summer 2008, the US suddenly started to talk about Basel IA, claiming that Basel II regulations were intended for financial institutions of different nature than most of those in the US (excuse me?), at least that’s what you can figure from papers and protocols the US government and the BIS published.
Basel II involves the rating of the debtor to answer the queestion of how much equity would be needed to lend money to someone. Basel I relies only on the kind of debtor, in other words, a Basel I bank can lend as much money to a government as it wants as long as the reserve ratio is obeyed, because Basel I assumes governments never default. The second best reliabuility is assumed for other financial institutions, etc.
So yes, Japan implemented Basel II after a grace period fpr their banks, and the US didn’t.
ii) Reserve Requirements
Not only do US banks work around reserve requirements by using shadow accounts where they keep most of the money and for which applicable law does not require reserves. They also freeze accounts overnight and lend out the money, and when you transfer money it’s also being used. The latter is done around the globe, while the former isn’t, at least as far as I know.
Add i) and ii) and you simply don’t want to know how much money US banks lent to governemnts because that requires no equity and the money can be taken from an averaging pool which requires no reserves either.
Cheers.
Thanks equally for the interesting comments.
I’m primarily interested in the macro-economics of this, rather than specific shenanigans within the Banking system, since i’m exploring a theory that the underlying rules are flawed. The main reason most of my examples orient around the USA, besides they’re being so important in the world economy, is that they also have some of the most comprehensive open statistics for examination.
I’m not sure what you mean by ’shadow accounts’ – what i’ve seen so far, is that the information in the Call Reports is consistent with the information from other sources, so hiding considerable money in that context would be an achievement. Lending to the American government is otherwise known as buying treasuries, and the amounts outstanding of those is well recorded. Government debt is also separately reported in the D.3 Flow of Funds Report. The evidence there suggests that it is private lending in the form of commercial and private mortgage loans that have been issued to excess, rather than loans to government.
I haven’t done a survey on fractional reserve requirements – but i know the UK followed the US practice of practically 0 reserves, i believe in the early nineties. There is a well known problem here that Economics knows as ‘Bad money drives out the good’. If other banking centres were going to remain competitive with the US then they may have had little choice but to follow the american banking practices – foolish though that may be in the long term.
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Thanks for explaining your focus.
By “shadow accounts” I meant what the banks use to work around the reserve requirements. It takes an account for which applicable law doesn’t require reserves, so as I understand it, you as a customer open a bank account and allow the bank to keep most of the money really on a different account “behind it” so it doesn’t have to stick to the reserve requirements.
As I see it, you may be right about lending to the US government, because the US has a record off budget deficit as well, and I’m not so sure those are paid for by issuing treasuries. Much of it has been taken from funds with different objectives but a government can still borrow money directly, or so I suspect.
Apart from that, I was referring to lending in general, and I heavily doubt US banks buy only US treasuries. Otherwise, political influence of the US would diminish. So since Basel I does not require US banks to observe equity capital quotas when lending to governments, I wouldn’t be surprised to find many foreign treasuries off US bank balances, especially issued by governemnts of countries where the US maintains remote military bases.
Hmm. Well, since there aren’t any reserve requirements per se, i’m not sure where the banks would need to work around them. There has been some playing around with accounts being setup so that they do not fall under the definition of “Net Transaction Account”, and allow overnight sweeping – but i don’t believe it’s that relevant in the grand scheme of things.
I haven’t looked at the relative weighting of foreign treasuries – but there are a couple of things that come to mind there. For there to be a substantial number of treasuries issued by any government, that government needs to be borrowing money, i.e. it has a national debt. So as a first approximation, the amount of treasuries available is a function of, the size of the economy and the amount of government borrowing. Which means that the US government is one of the biggest suppliers of treasuries, just because it has a large GDP to borrow from.
There is definitely some accounting malarky going on with the way the social security funding is being handled, but that doesn’t have any particular money supply implications that i’m aware of. Compared to Europe, the US also has a lot more leeway to absorb tax increases, especially on the upper classes, which i imagine will end up being their way out of that one.
If you can show that proportionately to their relative national debt (see http://en.wikipedia.org/wiki/List_of_countries_by_external_debt), the US Banks are holding a disproportionate quantity of certain countries debt, that could certainly be interesting. I haven’t run across any factually based analyses that suggest that though.
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“Double bug” is a good way of describing the problem! Following the old systems design adage, I described the same phenomenon as a “double-blind” borne of the perverse interaction of two independent “layers of indirection” …in a 2008 letter to the Cisco Internet Protocol Journal:
http://www.cisco.com/web/about/ac123/ac147/archived_issues/ipj_11-4/114_letters.html
Nice to find someone else working in the same general space!