Demands for extra bank capital are hampering the recovery

The central constraint on economic recovery in the leading economies since mid-2009 has been officialdom’s pressure on banks to raise their capital/asset ratios. Also relevant – but to a lesser degree – have been the calls for higher ratios of liquid assets to total assets. Both the higher capital/asset and liquid asset/total asset ratio are part of a Basel III package of banking rules. The package is to be applicable in a number of “leading countries” – the newspapers sometimes refer to 27 of them – which are unfortunate enough to have decided to belong to this international “club”.

Because of the ongoing bargaining about the Basel III rules (which is mixed up in confusing ways with meetings of the G20 and the European Union), banks have been shrinking risk assets and/or restricting asset growth. They have had to do this in order to comply with official demands, whatever their own business preferences. That has checked the growth of bank balance sheets, including the growth of the deposit liabilities which constitute the quantity of money. The pressure for higher capital/asset ratios has therefore been associated with virtual stagnation of the quantity of money (on the broadly-defined measures) in the USA, the Eurozone, the UK and Japan for about 18 months. Because the growth of money and nominal GDP are related, the recovery has been disappointingly feeble. In most countries unemployment remains close to its peaks. Indeed, in the Eurozone unemployment is still rising.

A salient feature of the world’s leading economies in the last year to 18 months is that the growth of demand and output has typically run at trend or beneath-trend rates despite vast so-called “fiscal stimulus” (i.e., increased government spending and budget deficits) and virtually zero interest rates. However, all is not lost. At its latest meeting the Basel Committee of Banking Supervision agreed to ease the definition of bank capital and, more important, to extend the transition period in which the higher capital/asset ratios would have to take effect. Reports vary, but the deadline now appears to be 2018 (or even 10 years from the finalisation of an accord) instead of the end of 2012.

I think the emphasis has been in the wrong area. The capital/asset ratio does not resolve the initial problem, that banks lent to people that could not repay. If the borrowers were more stringently selected then the repayments would have been consistent and the question of bank capital/asset ratio would not be an issue. This has still not been tackled in my opinion and is the main constraint.

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