A Downside of Increased Bank Regulation.

Over the past few years one of the people whose views on the economy I have come to respect is Steve Hanke from Johns Hopkins University.

I want to quote here from an article Hanke wrote for the November 2011 issue of “Globe Asia.” Steve’s case here is that increasing bank capital destroys money and consequently liquidity and asset prices.

The remainder is quoted from Hanke’s article.

As part of the money and banking establishment’s blame game, the accusatory finger has been pointed at commercial bankers. The establishment asserts that banks are too risky and dangerous because they are “undercapitalized.” It is, therefore, not surprising that the Bank for International Settlements located in Basel, Switzerland has issued new Basel III capital rules. These will bump banks’ capital requirements up from 4 percent to 7 percent of their risk-weighted assets. And if that is not enough, the Basel Committee agreed in late June to add a 2.5 percent surcharge on top of the 7 percent requirement for banks that are deemed too-big-to-fail.

The oracles of money and banking have demanded higher capital-asset ratios for banks. And that is exactly what they have received. Just look at what has happened in the U.S. Since the onset of the Panic of 2008-09, U.S. banks have, under political pressure and in anticipation of Basel III, increased their capital-asset ratios.

The establishment has erupted in cheers at the increased capital-asset ratios. They assert that more capital has made the banks stronger and safer. While at first glance that might strike one as a reasonable conclusion, it is not. For a bank, its assets (cash, loans and securities) must equal its liabilities (capital, bonds and liabilities which the bank owes to its shareholders and customers). In most countries, the bulk of a bank’s liabilities (roughly 90 percent) are deposits. Since deposits can be used to make payments, they are “money.” Accordingly, most bank liabilities are money.

To increase their capital-asset ratios, banks can either boost capital or shrink “risk” assets. If banks shrink their “risk” assets, their deposit liabilities will decline. In consequence, money balances will be destroyed.

The other way to increase a bank’s capital/asset ratio is by raising new capital. This, too, destroys money. When an investor purchases newly-issued bank equity, the investor exchanges funds from a bank deposit for new shares. This reduces deposit liabilities in the banking system and wipes out money.

So, paradoxically, the drive to deleverage banks and to shrink their balance sheets, in the name of making banks safer, destroys money balances. This, in turn, dents company liquidity and asset prices. It also reduces spending relative to where it would have been without higher capital/asset ratios.

By pushing banks to increase their capital-asset ratios to allegedly make banks stronger, the establishment has made their economies (and perhaps their banks) weaker. This is certainly the wrong medicine to prescribe when the economy is weak.