Nine years after the start of the financial crisis, there has still been no rational discussion about bank capital. Blame this on the banks, who haven’t set out the arguments.
Money is a figment of the human imagination. Historically, we’ve tinkered with ways of making it appear real – stamping coins, printing notes, putting up the kind of impressive buildings that humans conceive to sustain their other belief systems. But in the end, numbers are a human concept, and money is a subset of the concepts that relate to them.
Money has two dimensions: volume and price. I lend you $10,000 at an annual rate of 5 per cent. The volume is 10,000 and the price $500 a year. A regulator sets my base rate of interest. The final price depends on other factors, like the premium I might add because some borrowers won’t pay me back (risk), and my costs. The price will, to some extent, determine volume. If money is expensive, there’ll be fewer borrowers, so the volume should go down. Theoretically, if money is cheap, there should be more borrowers, and volume will go up.
But as we can see, it doesn’t work like that. According to the capitalist model, enterprises acquire assets which generate revenue: machine tools, trucks, bags of cement. Those assets are acquired from elsewhere in the economy, in a merry-go-round of manufacture and distribution of the means of production. The principal assets which a bank acquires are loans – e.g. the $10,000, which generates $500 of revenue a year. But here’s the difference. Unlike any other enterprise, banks can create their assets out of thin air.
They can do this because of the way that we choose to write down transactions in units of money. This goes back to a fifteenth century codification of accounting practices, known as double entry bookkeeping. When I borrow $10,000, the bank puts that number in my account. It sits there just like a deposit from my earnings, and so counts as one of the bank’s liabilities, now recorded on the liability side of its balance sheet. In parallel, the bank records the loan that it has made to me. This is an asset, earning it revenue, so it goes on the asset side of the balance sheet. The new deposit which the bank has put in my account is funding the loan which the bank has made to me.
Totally shocking, once you realise it – that the entire material world has been built on this extraordinary flight of the human intellect. Access to credit on fair terms allows people to monetise their ingenuity and labour for their own benefit, rather than that of some wealthy patron. Banks have democratised prosperity. They are the most perfect socialist institutions that we have yet devised. Bank assets make all other human-built assets possible. They are on every high street not because they are a sector of the economy, but because they are essential to all of it. It’s their lending that matters, more than their transacting.
Credit creation explains why modern monetary policy doesn’t work. If banks can create money at will for worthy borrowers, there’s no equilibrium: hence why price is not the only determinant of volume. There’s a more effective, alternative determinant. As a regulator, you can choose a number to set as the ratio between the capital you require me to hold, and my assets. You might say that I must have a capital to asset ratio of 10 per cent. In which case I need to hold $1,000 as capital to support that $10,000 loan. If I want to increase my volume of assets, I have to increase the volume of my capital first.
So banks’ activities consume capital, according to a ratio set by regulators. If those activities consume capital faster than they can pay for or generate it, banks don’t do them. It’s taken this long for investors to realise that high capital ratio requirements and low interest rates make banks uninvestable. Perhaps modern economists struggle with a concept as simple as a ratio.
Because it is the volume of money that impacts the economy more than the price. If new credit is not being created by the banks to create new human-built assets – “growth” – the economy will go nowhere. And printing money to “ease” the quantity problem does not work because, by definition, it only buys existing assets.
Banks with high capital ratios might have the capacity to absorb higher losses. That does not mean they have the capacity to create more assets. When banks can’t invent money, economies don’t grow. We confuse the role of banks with bankers’ behaviour. That’s a mistake. No wonder, having tinkered with price, the European Central Bank is trying to get some volume back.