Monday, 11 February 2013

Economic Myth: Banks aren't lending because they need to build up capital

See for example the opening sentences of an article in today's FT: "It is tough to get money out of a bank these days. Five years after the financial crisis, most are still trying to rebuild their capital and reputations."

This is about as dumb as saying: "It is tough to get a hire car these days. Five years after the crisis, most car hire places prefer to keep their cars on the forecourt to rebuild capital instead of hiring them out."

People who say things like this are confusing two completely different sides of bank balance sheets and/or totally unclear as to what they mean by "capital" (even if we use the term in the narrow context of banking*). Let's refer back to a diagram I posted in 2011:

If our goldsmith has some liquid assets on the left hand side of his balance sheet (gold coins in the safe) then clearly:

a) whether he lends them out or not makes absolutely no difference to the right hand side of his balance sheet in the short term. The depositors are indifferent whether the banks has assets of 90 gold coins' worth of loans + 10 physical gold coins or 100 gold coins, or any combination which adds up to 100 gold coins.

b) if the goldsmith does not lend them out, he is not earning interest, most of which gets passed on to the depositors on the right hand side of his balance sheet.

And the same applies to a bank, if instead of £100 million in loans, it has £95 million in loans (earning interest) and £5 million in cash or near-cash (not earning interest) on the left hand side of its balance sheet then clearly:

a) whether or not it lends out that cash or near-cash makes absolutely no difference to the right hand side of its balance sheet in the short term. The depositors and shareholders are indifferent. It does not change the value of "share capital and reserves".

b) if the bank does not lend out its non-interest earning cash or near-cash and still has to pay interest to depositors, it is not earning any extra profit which would go into "share capital and reserves" on the right hand side of its balance sheet. So in the long run, it is eroding its "share capital and reserves".
The only explanation for this is that banks are more worried about the ratio of deposits-to-share capital on the right hand side than they are worried about the ratio of liquid assets (cash and near cash) to illiquid assets (loans at interest) on the left-hand side.

For example, if the new "Basel" rules say that banks have to have 11% capital and reserves on the right-hand side instead of only 10%** and banks have £10 million spare cash or near-cash, then they can improve their 'Basel capital adequacy" ratio from 10% to 11% by repaying £10 million of deposits, so they end up with £80 million of deposits and "Shareholder capital and reserves" of £10 million (i.e. unchanged) so their Basel ratio is now 10/90 = 11%. They could of course achieve the 11% ratio overnight by simply persuading £1 million's worth of depositors to subscribe for shares (a debt-for-equity swap), but let's put that to one side.

But of course the politicians do not grasp this (neither do they or most people grasp that the term "in reserve" and "reserves" are two completely different things - look again at those two balance sheets) and want banks to hold more liquid assets on the left-hand side as well.

Which puts the banks nicely in a bind. If their borrowers dutifully repay loans (in cash) so that a bank ends up with £10 million in the safe, should it hang on to that to keep the politicians who are crying out for banks to have more liquid assets happy; or should they take it out of the safe and repay depositors to keep the politicians who are crying out for banks to reduce their gearing ratios*** happy?
* "Capital" means different things in different contexts. In the wider sense, the only things which are capital are machines, buildings, know-how, the skills you use in your job etc. Money is not "capital" at all, it is a way of measuring/recording indebtedness on one side and ownership on the other. Money is an abstract concept; when they talk about "capital disappearing into tax havens" what they mean is that the records of who owns what are now being kept abroad; they do not mean that tax avoiders are taking all their machines, buildings, know-how and skilled workers and moving them physically to tax havens.

** Yes, I am perfectly aware that banks are allowed to operate on the basis of 3% or 4% reserves. 10% is just a nice round figure for doing these examples.

*** The gearing ratio is merely the inverse of the "share capital and reserves-to-total assets" ratio. In the diagram, the bank's share capital and reserves are £10 million out of £100 million = 10%. So the gearing ratio is 10. If the banks collects £10 million of loans and repays £10 million of depositors, it has a "share capital and reserves-to-total assets" ratio of 11% and a gearing ratio of 9.


Lola said...

Excellent analysis.

The real worry is that the banks and the gummint believe their own bullshit.

Votefor said...

So , where is the money or credit really going?

Mark Wadsworth said...

L, ta.

VF, as I said: "Money is not "capital" at all, it is a way of measuring/recording indebtedness on one side and ownership on the other"

It's a bookkeeping exercise, comes out of nothing when indebtedness arises and disappears when loan repaid.

If you do me a favour, then I owe you a favour. You mow my lawn when I'm on holiday, I feed your pets when you are on holiday.

We could value that "favour" at £10, so once you have mowed my lawn, I have a liabilty of £10 and you have an asset of £10. Once I have fed your pets, then the debt is repaid, I no longer have a liability and you no longer have an asset.

See also for fuller explanation.

Pablo said...

"Capital" means different things in different contexts. In the wider sense, the only things which are capital are machines, buildings, know-how, the skills you use in your job etc. Money is not "capital" at all

No, money is not capital: capital is a subset of wealth and must be material. It makes little
sense to use the term to describe human qualities or attributes of labour.

Mark Wadsworth said...

P, fair enough, that gives us an even narrower definition.

But to my mind, if there are two people doing a job, and one of them devises a clever little tool to help him do it faster or better; and the other devises a clever little trick to help him to it faster or better ("know-how") then there is not really that much difference.

In future, people who want to do that job will either a) spend money (or time and effort) on building themselves a copy of the tool; or b) spent money (or time and effort) on learning the little trick.

You could e.g. compare a tax driver's sat-nav with rote learning of maps by heart.

And what about software - when presented with some tricky decision, a lot of people set up a spreadsheet (that's "labour"). Some of these turn out to be useful for other things, so you use the same spreadsheet again (so the spreadsheet is "capital"). At which stage does "labour" become "capital"?

Lola said...

MW / P - Yep it seesm to me that it is the combination of the factors of land, labour and capital that lead to production. Labour and capital can be intermingled as MW states, only 'land' is unique - hence Georgism. (I am using land in its narrowist sense as in the 'site' - the 'site' only achieves a value by what is done on it by the other two factors and where it is located, again with reference to the other two factors.)

Mark Wadsworth said...

L, ta.

In an economic sense, "land" includes not just geographic locations but (nearly) all barriers to entry* and/or government-protected monopolies.

So it includes the value of an FSA registration, a taxi driver licence, radio frequencies, cherished car number plates, fishing licences, aircraft landing slots, patent protection.

All these things only have market value because they are limited in supply and you need one to set up in business or do whatever it is you want to do - regardless how much labour and capital is at your disposal.

They have no inherent value and all their market value is derived by creaming off value created by labour and capital, or indeed by nature.

* The only exception would be where the minimum efficient scale is more than half the size of the total market.

Pablo said...

MW: You're looking at it from the pov of effects, whereas I'm looking at it from the pov of causes. If you want to look at it from the pov of effects, you could just as well argue that the same improvement in production could be achieved by obtaining better land, and then where are you? You have blurred the distinction between all 3 factors.

L: I have it in mind that the site aquires value from the location, from scarcity, from its potential to produce wealth, not from what is actually done on it.

Mark Wadsworth said...

P: "the same improvement in production could be achieved by obtaining better land, and then where are you?"

Short answer: somewhere else, obviously.

Long answer: In most cases, you can achieve a better result using different "land". It's still "land".

There are different categories of FSA registration. A taxi driver licence is worth more the fewer of them there are. Frequencies on which you can broadcast 4G are worth more than long wave fgrequencies. The number A 1 is worth more than the number AB 21.

Now, when you say "better land" you might mean natural properties of it rather than location, i.e. stable not prone to subsidence.

That is natural features and not "capital" not in any way shape or form.

In the same way, prospecting equipment and the skills of engineers and welders which result in an oil rig are truly "capital" but the oil under the ground is not "capital". It is just there for the taking. (and I suppose, the value or the iron ore which had to be mined and smelted to make the rig).

Lola said...

MW Of course, official licencing is 'rent seeking' by gummint, where the tenants collude with the gummint for their own benefit. In my libertarian dream world it wouldn't be allowed...

Bayard said...

"The real worry is that the banks and the gummint believe their own bullshit."

The real real worry is that they don't think it's bullshit.

Mark Wadsworth said...

L, B, that is the eternal dilemma, isn't it? Looking at it from the outside it is impossible to distinguish between rank stupidity and blatant corruption.

Votefor said...

OK , Your comments om this please ( Bill Bonner)

Let's see, what is really going on? What kind of game are central bankers playing?

Central banks give their friends and favourites access to almost unlimited amounts of money at nearly zero rate of interest. What do they do with the money? They buy valuable assets – houses, office buildings, companies, gold and silver.

Ordinary households aren't getting the money; it's locked up in the hands of the 1%... or even the one tenth of 1%. And there aren't enough of these rich insiders to move consumer markets. Toilet paper and gasoline move up slowly. But prices for stocks, bonds, Manhattan real estate and expensive works of art go up fast.

Meanwhile, home ownership, by the people who live in them, is going down.

Stock ownership, by the middle class, is also on the decline.

Powerful, well-financed groups are buying. Middle America – short of funds – is not.

Mark Wadsworth said...

VF, that looks like a fair summary to me. Not much to argue about there.

Votefor said...

Thanks for that , I will now try to formulate a strategy to get me
and mine through the upcoming upheavals.

LVT does seem to cure most financial woes , why don't the more sensible politicians advocate it? Is it perceived as putting more power in the hands of the state perhaps? Or ,is it simply thst people hate the idea of a NEW tax with only the promise of other taxes being abolished , the politicos are not to be trusted.

Mark Wadsworth said...

VF, why?

Because the bankers, the large landowners and the senior politicians are the same people, hence and why they pump out propaganda swallowed by supposedly left wing and right wing voters alike.

For a long of the sort of crap which people believe, I refer you to the KLN blog.