Does boosting bank capital requirements limit output or growth?

by on July 31, 2011 at 2:54 pm in Economics, Uncategorized | Permalink

Paul Krugman has an intemperate polemic against Alan Greenspan, for instance:

It’s terrible on all counts; but the most offensive thing intellectually is the incredible fallacy of claiming that higher capital requirements for banks amount to keeping resources idle…the man once revered as a demigod of finance doesn’t understand basic economics — or, more likely, that he chooses not to understand what he, amazingly, is still being paid to not understand.

There is no mention of the actual literature on this topic.  Here is one summary of some common views:

Hall (1993) presents evidence that from 1990 to 1992 American banks have reduced their loans by approximately $150 billion, and argues that it was largely due to the introduction of the new risk-based capital guidelines. He goes even so far as to say that “To the extent that a “credit crunch” has weakened economic activity since 1990, Basle-induced declines in lending may have been a major cause of this credit crunch.” Hence, it is not an overstatement to say that Basel I did have an impact on bank behavior as it forced them to hold higher capital ratios than it otherwise would have been the case.

It is a common belief, though by no means universally held, that the implementation of Basel meant a slower U.S. recovery from the recession of the early 1990s.  Here is a summary of some of the international evidence, plus there is a general literature survey in the first few pages at that link; see for instance Peek and Rosengren (the term “capital crunch” will help in Google searches).  Perhaps the literature on the early 1990s may not apply today, but Greenspan’s claim is not incoherent a priori.  Furthermore the Greenspan piece links to an FT piece which a) is consistent with his general account, and b) shows various Europeans, not all of whom are bankers, sharing the same worry for today, and c) makes it clear Greenspan is not committing the “Junker fallacy” of confusing paper holdings with real resource destructions.  The negative effects come through a tax on financial intermediation.  Maybe just maybe one could criticize Greenspan for not being clear enough on the mechanism, but he is still right on the comparative statics and certainly not spouting nonsense.

At the theoretical level, papers on Modigliani-Miller deviations, and the interrelation between production and finance, also make Greenspan’s argument acceptable, if not necessarily correct; one can even look to Joe Stiglitz here.  Krugman admits that capital requirements lower bank risk-taking but of course that can lead to less lending and, in many future world-states, lower output.  That may well be a good thing, since it lowers systemic risk and thus helps output in some world states, but it’s wrong to deny the significant possibility of a real opportunity cost.

Also, bank capital requirements are not well understood in terms of a pure Modigliani-Miller debt-equity swap.  For one thing, the capital requirements favor some asset classes over others, and arguably in a way which limits expected growth.  The capital requirements also involve a commitment to particular accounting standards.

On matters of policy, I do in principle favor significant increases in capital requirements for banks.  But should we push to impose those tougher requirements today in such a weak economy?  Perhaps Krugman would be eager but I’m not so sure.  For all his worries about repeating the mistakes of 1937-8, Krugman doesn’t seem to recognize this may well be another step down that path.

1 Martin July 31, 2011 at 3:04 pm

There was a paper on this topic earlier this year by Admati, Hellwig, DeMarzo and Pfleiderer.

“Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive”

Part of the Abstract:
“We conclude that bank equity is not socially expensive, and that high leverage is not necessary for banks to perform all their socially valuable functions, including lending, deposittaking and issuing money-like securities. To the contrary, better capitalized banks suffer fewer distortions in lending decisions and would perform better. The fact that banks choose high leverage does not imply that this is socially optimal, and, except for government subsidies and viewed from an ex ante perspective, high leverage may not even be privately optimal for banks. Setting equity requirements significantly higher than the levels currently proposed would
entail large social benefits and minimal, if any, social costs. Approaches based on equity dominate alternatives, including contingent capital. To achieve better capitalization quickly and efficiently and prevent disruption to lending, regulators must actively control equity payouts and issuance. If remaining challenges are addressed, capital regulation can be a powerful tool for enhancing the role of banks in the economy. “

2 l.a.guy July 31, 2011 at 3:13 pm

It’s good to be the Krugman; he gets to tell everyone else how stupid they are and what the correct course of action would have been and the luxury of never having to take responsibility for the consequences of any of his sure fire prescriptions if they fail.

As far as increasing capital requirements during a recession; since liquidity in the banking sector doesn’t seem to be the problem then how would reducing it incrementally in order to ensure a bigger safety net hurt the economy?

3 Rahul July 31, 2011 at 3:29 pm

Seems fairly of academic interest right now. Are many projects having trouble getting financed today because of conservative banking? I fear the problem lies in designing positive NPV projects at all in this economy. We can get money if we knew where to invest it in.

4 Ryan July 31, 2011 at 3:39 pm

I think there’s a large political element here. The banks are already fighting new capital regulations tooth and nail (and largely winning). Even assuming Greenspan is right, the only time when it is feasible to impose new capital requirements is right after a financial crisis when the memory is fresh and the banks have less leverage. That moment is already passed for us, but while it seems unlikely now, I would wager it next to impossible in five years or so. Constrained lending might result in somewhat lower output, but giant financial crises quite definitely result in lower output.

Alternatively, one might imagine a scheme that doesn’t kick in for a few years, or when some growth target is reached, but the question seems largely academic.

5 Orange14 July 31, 2011 at 3:39 pm

It is far better to force banks and other financial institutions to have a fixed capital requirement and if they want to increase lending do it through raising capital and/or spinning off investment trusts. Left to their own devices, such institutions will always gravitate towards Minsky-style Ponzi financing. It’s also interesting to go back and see what a bunch of economists (including Krugman, Samuelson, Minsky, Summers, Volcker, Feldstein, Grundfest – a good mix of both liberal and conservatives!) had to say about the risk of economic crisis. Papers are all free at:

6 mulp July 31, 2011 at 3:41 pm

“It is a common belief, though by no means universally held, that the implementation of Basel meant a slower U.S. recovery from the recession of the early 1990s.”

The downward pressure on real estate prices (back to and below the cost of construction) had no impact?

I find the ignorance of the 80s economy, and especially the collapse of the 80s asset bubbles, to be amazing given the large number of boomers who had to have been hit by it.

The bubbles in the 80s were smaller than the bubbles of the past decade, so the recovery this time should be compared to to economic history with a 20 year shift, almost exactly.

And the response in Texas was higher capital requirements that the Texas government maintained with jackboot regulation on mortgage lending to the present day.

7 Alex Tabarrok July 31, 2011 at 3:41 pm

I was puzzled by Krugman’s post also as it seemed like a rejection of Diamond-Dybvig in favor of Rothbard.

8 Ryan July 31, 2011 at 3:42 pm

Er, by “leverage,” I mean “political leverage.”

9 Jay July 31, 2011 at 3:52 pm

These days, listening to Krugman is like listening to the nut jobs in the ‘Tea Party’. Krugman’s arguments have become so weak that his talk on the Sunday morning talk show went like this…..

Define rational as Progressive. Define everything else as irrational.
The US government should take rational measures.
Therefore the US government should listen to Progressives.

*I always said, if you need to call your party the Progressive party to get people to believe that you support measures that lead to progress your policies definitely going to lead us down the wrong path.

10 R Richard Schweitzer July 31, 2011 at 3:57 pm

All of these “tempests” seem to be directed at what is assumed to be an economic system in the Western World in which the function of Banks and “Banking” (as well as the concept of what constitute “banking”) has not changed since 1905.

“Capital” in most of the West is comprised of the surplus of prior production over consumption levels (basically from “profits”) through the current period.

Is most, or some lesser amount, of that Capital today within the power of Banks to deploy? Or, does that force lie elsewhere?

Which entities hold today’s bulk of that Capitall, and what operators within those entities have the power to determine whether and how it shall be deployed – and to what ends?

A plausible case can be made that industries and businesses now contain the Capital from their production, and continue to retain it – thereby giving the managerial class control to determine the major effective deployments of Capital, in accord with their motivations and objectives. Those activities are reflected in aggregations, expanding “market shares,” and other enterprise “enhancements.” Banks may play along to share in the benefits of “lubricating” those deployments.

Capital in both businesses and banks consists of assets; examine them respectively, which can produce surplus from deployments? What are Bank assets today? What are the surplus assets of businesses today? Banks today are becoming “service stations,” not the implementers of enterprise. Their Capital should be examined accordingly.

11 Brett July 31, 2011 at 4:15 pm

You keep at it and make sure Krugman’s vast political power doesn’t end up weakening the economy.

12 Charles Rowley July 31, 2011 at 4:50 pm

The 1937 mistake was re-electing a communist into the White House. With tax rates rising to 95 percent on top incomes, and with leading capitalists under indictment on false charges, there was no incentive to invest. A well-justified capital strike provoked the second downturn. Prices levels had dropped sufficiently to restore the real money supply to pre-1930 levels. In this respect, Friedman and Schwartz mis-interpreted the Great Depression.

13 Jason July 31, 2011 at 5:12 pm

Top *marginal* rates. You have to make ~$5.8 million in 1944 to reach 90% tax rate and your take home would still be equivalent to about $4 million today.

I find it hard to believe the marginal utility of that 5.8 millionth dollar was more than 5% of the first dollar.

14 Millian July 31, 2011 at 6:00 pm

And the MU of the 100th dollar is a similarly tiny fraction of the first dollar. The difference between living and dying. Good thing that’s not how we choose tax rates.

15 Jason August 1, 2011 at 3:10 pm

That is incorrect. The marginal utility of the 100th dollar is about the same as that for the first dollar. The desired precautionary savings rate is about 15% of annual income for the bottom quintile (~$20k), dropping to about 7% for the 4th quintile (~$90k). So the marginal utility of the 90,000th dollar is only about half the 20,000th. So the MU of the 100th dollar has to be greater than 50% of the first. Doing a linear projection that is definitely a poor estimate, but a better estimate than simply making something up, we find the MU of the 100th dollar is about 99.9% of the 1st.

16 FYI July 31, 2011 at 5:07 pm

Krugman continues his quest to be the most pompous commentator in our media today. That is not a small accomplishment.

He has become such an arrogant operator that I suspect people will not take him seriously anymore even when he gets something right. It is a new variant of the boy who cried wolf effect – I shall name it “the economist who was an ass” effect.

17 Bernard Yomtov July 31, 2011 at 5:19 pm

Krugman continues his quest to be the most pompous commentator in our media today.

Pompous? Have you seen or read George Will lately? Or Bill Bennett, for that matter? Those guys are leagues out in front. And they’re idiots to boot.

18 FYI July 31, 2011 at 7:30 pm

None of these guys hide behind the facade of being a highly knowledgable Nobel winner economist who is just analyzing the data and helping us poor ignorants to understand the way things work.

Krugman should abdicate his former profession and assume his new role as a propagandist.

19 Rahul August 1, 2011 at 1:01 am

They are all three (Will, Bennet Krugman) pretty bad.

Why debate who’s worse?

20 Paul August 1, 2011 at 6:44 am

Why debate it? Because your premise is false. If you must throw in a conservative with Krugman, use Hannity or Rush. They sometimes mirror Krugman’s dogmatism, petulance, and unyielding ego. It is beyond unfair to lump Will and Bennet in with Krugman. Will is a graceful writer and thoughtful man. If you really listen to Bennet’s show, instead of just assuming what goes on there, you will find a show that is thoughtful, temperate, wise, and that gets – for the most part – guests who are the same.

21 Jason July 31, 2011 at 5:18 pm

A question for the monetarists: essentially capital requirements only change the amount of money the Fed needs to put into the economy to maintain a particular inflation rate. I.e. the effect of having a 10 to 1 reserve requirement means the fed has to put in X dollars into the money supply to maintain inflation targets, while a 20 to 1 reserve requirement means the fed has to put in X/2 dollars to get the same amount of money in the economy.

I don’t see what effect that could have on the economy, from a monetarist standpoint. It could change the distribution of institutions that do the lending, but the economy would grow the same amount.

22 Ugo Panizza July 31, 2011 at 5:24 pm

I agree that this is not the right moment to implement policies that reduce credit (even though I am not sure that right now lending is low because of regulation). However, our paper titled “too much finance?” (a summary is here: suggests that the US is on the wrong side of a lending Laffer curve. If this is the case, less credit would not have a negative effect on long run growth.

23 srsly? July 31, 2011 at 7:44 pm

While reductions in capital lending would be bad in this economy, the risk on the other side of the coin – should loans go bad (again) – involves bank bailouts.

I’m not sure that the economy and the American public’s psyche could handle another round of that.

24 Bill July 31, 2011 at 8:17 pm

Banking is no fun without high leverage.

25 Bill July 31, 2011 at 8:19 pm

By the way, I don’t know how you can make the argument that capital requirements have restrained lending when the Fed is willing to lend to banks at .25%.

26 babar July 31, 2011 at 9:07 pm

it stands to reason that requiring bank capital would neither be contractionary nor expansionary, because monetary policy could adjust around it. but changes in bank capital requirements (whether because of legislation or other reasons) could be, no?

27 Joe Smith August 1, 2011 at 2:06 am

It simply does not lie in Greenspan’s mouth to argue for less regulation of financial institutions given that he stood aside while Wall Street ran amok and poured several trillion dollars down a rat hole.

Capital requirements are not going to be any drag on Wall Street banks any time soon given that they have close to two trillion dollars in excess reserves – that is, they have two trillion dollars of deposits (or capital or some combination) that they could lend with their current capital that they are putting on deposit with the Fed instead.

28 JM August 1, 2011 at 2:55 am

MR, Krugman is actually right here.

You could look at 3 different effects of bank capital regulation on the real economy.
a) Short run impacts of bank sector shrinkage (the ’basel impact’ papers you cite: in the short run, you might have suboptimal lending if banks cut lending rather than issuing more equity when they attempt to repair their capital base.
b) Long run impacts on real economies of different bank gearing level: if regulators set bank capital requirements too high, that might hurt real consumption or investment if it results in a debt:equity level that is suboptimal out in the real economy.
c) Resource costs of financial instruments like equity and debt.

Krugman doesn’t note the literature on a) and b) because Krugman’s point was that Greenspan is wrong on c).

Greenspan claims that bank capital is a real resource cost. He writes: “Any excess bank equity capital also would constitute a buffer that is not otherwise available to finance productivity-enhancing capital investment.” Greenspan equates bank capital explicitly to ‘building materials’ or a ‘stock of vaccines’.

Krugman says Greenspan’s claim is wrong. Krugman is right. A permanent increase in vaccine stocks of $1 will indeed cost at least $1 in consumption or investment (more if the vaccine stock expires before it is used and is replaced). But a permanent increase in bank capital ratios does not have a resource cost. Bank equity and debt are just different types of conditional claims on bank assets.

What am I missing – Greenspan has fallen into a version of your ‘Junker fallacy’ hasn’t he? It’s a basic error.

Is it important enough to launch an ‘intemperate polemic’ about it, as you say Krugman did?

Only if you think it’s bad that Greenspan ran the fed for almost 2 decades, deregulating the economy to the point of financial collapse, while under the incorrect belief that bank equity has a real resource cost and bank debt doesn’t.

29 Matt Young August 1, 2011 at 3:27 am

In the latest GDP revision fewer vaccines were sold and more remained in stock then bankers expected. Bankers were inaccurate. Hence the Gross National Vaccine was revised downward. To increase banker accuracy, they need to loan less money for vaccine shots and hold more money in reserve.

Whatever they use for reserves will do as long as its tradeable.

30 Jonathan August 1, 2011 at 10:31 am

This is one of the most helpful sentences I have read in weeks. Count one reader interested as hearing more on this, to the extent this is a topic of interest to you two.

“For one thing, the capital requirements favor some asset classes over others, and arguably in a way which limits expected growth.”

31 Curtis August 1, 2011 at 5:25 pm

I don’t get the Krugman thing. He is always telling everyone else how they believe in ferries that have different opinion than his and that all the studies back him up. But he rarely provides the studies for us to review. I think he still lives in 1937 colonial world where all demand is Anglo centric. That is no longer the world we live in. Keynes and Hayek are both dead. So are their ideas. They were great thinks and both help create a new economic model for the 21st century but neither models is sufficient. Krugman can’t seem to grasp the death of Keynes. There is more on this at What can we do to get people like Charlie Rose to quit having him on the TV as if he actually has any real insight?

32 JLD August 2, 2011 at 10:16 am

Keynes … dead. By this logic, so is Adam Smith.

Let’s put the cards on the table. People, especially conservatives, will use any means to their ends. Thus, so much has been falsely attributed to Keynes that his [attributed] works not are second in size to the Civil War section at the Library of Congress.

Economics is not a science—there are too many variable and too much opportunity for incentive caused bias.

Take this issue. Greenspan, by events, has been totally discredited. He will say or do anything to regain favor (and fees and invitations to public events), so up pops a piece by him in the FT (which needs to sell papers). Greenspan has to repackage the old shit in new clothing—got to restart the engine of privatizing profits and socializing costs, of which the key control is bank capital, to earn a fee. (If someone puts enough money into the game, they will start wanting control—think Tea Party—which is contrary to the people who pay Greenspan his fees).

The first task of economists ought to be how to purge people like Greenspan—where he a lawyer or doctor, would could defrock him for incompetence.

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