George Osborne the cuckold.

Osborne, along with finance ministers in other leading countries, have been completely fooled, hood-winked and out-smarted by private banks.

Since the crisis erupted, various worthy committees have, as we all know, been set up to re-examine bank regulation (Basel III, Vickers, etc). And the net effect of those committees has been near enough non-existent. In particular, the  3% equity to gross asset ratio (henceforth “capital ratio”) has not changed.

As for the UK, George Osborne could not even bring himself to adopt the 4% ratio advocated by Vickers: Osborne reduced that to 3%.

So what reasons do George Osborne and his fellow dimwit finance ministers round the world have for sticking to 3%? Well it’s the nonsense promulgated by private banks, and swallowed hook line and sinker by Osborne & Co that equity finance for banks is expensive. So, increase the extent to which a bank is funded by shareholders, and the cost of funding the bank rises – or so private banks will tell you. And those increased costs would be passed on by banks to borrowers, which would discourage borrowing and thwart economic growth: certainly the last thing we need when trying to escape a recession – so private banks will tell you.

And for the naïve, private banks seem to have a point. That is, the return demanded by bank shareholders is indeed higher than the return demanded by depositors. But there is a whapping great flaw in that argument, pointed out by Franco Modigliani and Merton Miller. It’s a desperately simple flaw, and it goes like this.

Shareholders demand a higher return than depositors because shareholders are first in line for a hair cut when a bank is in trouble. Put another way, shareholders carry a risk.

But – and this is crucial – the total amount of risk involved in running a particular bank which makes loans of a given quantity and type is a GIVEN. It’s fixed  - regardless of what adjustments one makes to capital ratios. I.e. adjusting capital ratios has NO EFFECT on the total risk involved. Ergo adjusting the ratio has NO EFFECT on the total charge that shareholders or “risk bearers” will make for carrying said risk.

In short, adjusting capital ratios has no effect on the cost of funding a bank.

Not  convinced? Well you might like to know that there are successful lending institutions in Britain where the ratio is WAY ABOVE 4%. How big do you think it is? 10%? 40%? Nope: it’s a whapping great 100%!!!!!

Those lending institutions are mutual building societies. Those institutions don’t have formal shareholders: they just have depositors. Thus depositors are in effect the shareholders, as Mervy King rightly pointed out. As King put in reference to those depositors “in a mutual organisation they are, in effect, the shareholders.”

But amazingly, and to repeat, mutual building societies manage to compete with private banks. Now that will baffle George Osborne. But it shouldn’t baffle anyone who has read and understood the above paragraphs.

And if you don’t believe the above paragraphs, then you might like to read discussion paper No 31 published by the Bank of England External Monetary Policy Unit’s discussion paper No.31, entitled “Optimum Bank Capital”. The authors conclude by saying that the very low capital ratios that have obtained in recent decades have arisen because “most regulators and governments seem to have accepted the view that “equity capital is scarce and very expensive” – which in some ways is a proposition remarkable in its incoherence….”.