Since early 2009 I have repeatedly made the point that sudden, large-scale bank recapitalizations – of the kind implemented in the UK particularly (but also elsewhere) in late 2008 – are deflationary. This has often puzzled people, since – surely – recapitalization makes banks safer and the safer are banks, the less likely are crises? (As far as I am aware, no evidence has been produced (by e.g., Mervyn King, John Vickers, the Basle regulatory bureaucracy et al) for the theory that macroeconomic instability, as measured, for instance, by the standard deviation of GDP growth, is inversely related to the banking system’s capital/output ratio. I am indeed pretty confident that – when tested against data – the theory does not hold up, but let this pass for now.) Instead, let me explain, again, why bank recapitalization is deflationary. What evidence can I call upon to substantiate my argument? Well, in effect the whole sorry financial and macroeconomic mess in the leading industries countries since mid-2007. Officialdom has repeatedly demanded that banks have more capital and, for all their problems, banks have higher capital/asset ratios today across the industrial world than they had in mid-2007. Yet the four years have been a misery and officialdom wants the banks to raise still more capital! How many more times does it have to be said that the key to macroeconomic stability is steady growth of the quantity of money at a low, non-inflationary rate? That is what matters, not the current rigid and ideological approach towards banks’ capital being taken in the Bank of England, H M Treasury, the US Treasury and, of course, the EU.
Banking system capital & the growth of the quantity of money
The first basic idea here is one that I have insisted on countless times, that the equilibrium levels of national income and wealth depend on the quantity of money broadly-defined. As far as I am concerned, this is standard theory understood and explained by, for example, John Maynard Keynes, Milton Friedman, John Hicks and numerous other authorities. If people don’ agree, there is no point in them reading further.
With that point given, we may then note that in the real world of contemporary business and finance the bulk of the quantity of money is represented by bank deposits. Banks’ liabilities consist of deposits and non-deposit liabilities, and non-deposit liabilities can be broken down into equity capital, bond capital and a residual (such as “deferred tax”). I am going to assume – for simplicity – that equity capital represents all of non-deposit liabilities. Banks’ assets and liabilities must of course be equal. Banks’ assets consist of “risk assets” and “safe assets” (like vault cash and cash reserves at the central bank), but let us – again to speed up the discussion – assume that risk assets are so much the dominant asset type (as they used to be in practice, before the current crisis) that total assets and risk assets can be regarded as the same thing.
Then it is almost inevitable that an increase in banks’ capital/asset ratios is deflationary. With capital given, an increase in banks’ capital/assets ratio can be implemented only by a reduction in assets. If assets fall, so too does broad money, reducing equilibrium income and wealth in nominal terms. This effect was obvious enough after the introduction of the first set of Basle rules in the late 1980s, and also in the quarters following the UK and other bank recapitalizations in late 2008.
Bank recapitalization lowers money balances in any circumstances in the first round
But what about a bank recapitalization that occurs when banks’ capital/asset (K/A) ratios is given? How can that be deflationary? At least superficially, banks do not need to shrink assets either before or after the capital raising. So what is the problem? We need to remember that banks’ liabilities consist entirely of money and equity capital in the present discussion, given the assumptions I have made. If banks’ total assets and liabilities are given (i.e., there is no cutback in lending, which practically everyone accepts is undesirable in current conditions), an increase in banks’ equity capital must be the expense of the quantity of money. Concretely, when – as a shareholder in a bank – an individual subscribes for new shares, he or she uses his/her bank deposit to pay for the shares. The bank deposit disappears (i.e., M falls) and the individual’s claim on the bank ceases to be monetary in form. Barclays‟ or Lloyds‟ ordinary share certificates cannot be spent in the shops.
I am not disputing that:
* 1. With the K/A ratio given, the recapitalization means that banks have more capital, so that in the second, third and so on rounds, the result of recapitalization may in fact be faster growth of assets and money than without the recapitalization, and
* 2. For banks that have a large „funding gap‟ (i.e., an excess of loans over „retail‟ deposits), the recapitalization may improve the banks‟ bargaining position in the inter-bank/wholesale markets.
* 3 All the same, the first round effect of a recapitalization is to reduce the quantity of money, even if the K/A ratio is unchanged.
Bank recapitalization in current circumstances, when banks’ equity is lowly rated by the stock market and banks are trading at less than book value
There is a further wrinkle here, which needs to be emphasized in current circumstances. Rightly or wrongly, banks have been subjected to a regulatory onslaught in the last four years. In my view (which may not be widely shared), officialdom has also adopted a cavalier attitude towards the property rights of bank shareholders. The net effect of the attack on the banks – combined with the bad mistakes that some banks had made before the crisis broke – is that banks’ equity now generally trades in stock markets at a discount to its book value. It follows that – when someone uses good 100-cent-in-the-$/euro or 100p.- in-the-£ money to acquire newly-issued bank shares – that person is immediately poorer by the discount. (And I ignore here the probability of “a double discount”, because new shares must be issued at a discount to the existing share price, even though that share price is less than book value per share.) Bluntly, when bank stocks are trading at a significant discount to book, private shareholders would be foolish to participate in equity fund-raising.
How, then, are banks likely to react if they are aware that officialdom (the BIS, the IMF, assorted G20 finance ministries) are breathing down their necks and demanding early, large-scale recapitalization? The answer is that they will try to narrow the discount to book by avoiding risks, cutting down on marginal assets and so on. A higher K/A ratio and a lower funding gap ought to narrow the discount to book value, and minimize the dilution of existing shareholders from a mandatory recapitalization. So – in current circumstances – the threat of a recapitalization may cause the banks to shrink risk assets and balance sheets, and hence to reduce the quantity of money.
I admit that this subject is complicated and open to a lot of debate. Nevertheless, I insist that bank recapitalization is deflationary in the first instance. Bank recapitalization in conjunction with an increase in K/A ratios imposed by regulators, central banks etc. is certainly deflationary, as the unhappy experience of the world economy in late 2008 and early 2009 demonstrated only too clearly.
Tim Congdon is the founder of International Monetary Research Ltd.