Bank capital ratio nonsense.

Here is an emperor with no clothes. He’s stark bollocking naked. But as is always the case with naked emperors, no one believes emperors, presidents etc could possibly parade in public with no clothes on.  So everyone sees clothes where there are no clothes. Anyway the naked emperor is as follows.

Thousands of person hours and tons of ink and paper have been devoted by Basel III / Dodd –Frank / Vickersetc to the question as to what capital ratios banks should have. Allegedly a higher ratio imposes additional costs on banks and Basel III has settled for a 3% ratio.

Funding a bank from capital is allegedly more expensive than funding via depositors, so everyone agonises over the cost benefit ratio here: lower capital ratios allegedly cut bank funding costs, but involve a bigger risk – agonise, agonise, agonise.

But wait a moment . . . as Mervyn King rightly pointed out, the depositors at British building societies (roughly equivalent to US savings and loan) “are in effect the shareholders”.

So in effect, the capital ratio with building societies is 100%. Yet they compete very effectively with banks!!!!!

So the whole “capital ratio” so called dilemma is nonsense. And the reason it is nonsense was of course pointed out by Messers Modigliani and Miller. That is, the risk of a particular bank going bust is a given, thus the reward demanded by those accepting that risk is a given. Thus the total number of shareholders amongst whom that risk is divided has no effect on the total amount of risk. That is, if you up the capital ratio, the risk per shareholder or per dollar of shares is reduced.

And if you go the extreme of making ALL THE CREDITORS of a bank shareholders, as is the case with building societies, that in no way hinders the ability of the relevant bank or similar entity to compete.

Actually the latter couple of paragraphs understate the point. That is, given a very small capital ratio, the risk of a bank failing is INCREASED. For example if the ratio is 3%, then the value of loans or investments made by the bank only needs to decline by about 3% and the bank is technically insolvent.

In contrast, if a bank’s only creditors are shareholders (as per British building societies), it’s virtually impossible for the building society / bank to become insolvent.

For another attack on the whole bank capital ratio shambles, see this article in the Financial Times entitled “Why bankers are intellectually naked” by Martin Wolf.