More Bank Capital Could Kill the Economy write Tim Congdon and the usually sensible Steve Hanke in today’s Wall Street Journal.
I was expecting a quantitative disagreement on plausible channels — some explicit violation of the Modigliani Miller theorem, some reason that splitting the pizza into 8 slices rather than 4 will help your diet, some argument that relationship lending is inherently tied to short-term funding, and so forth. Instead, we got treated to one of the most illogical conclusions I’ve seen on the WSJ pages for a long time.
This is a really important argument to revisit, at a really sensitive time.  Right now, the Administration wants to rethink Dodd-Frank. Great. But they could go in two ways: 2) increase capital a lot, and get rid of all the intrusive and stultifying risk regulation and anti-competitive regulation; 2) reduce capital requirements a lot, so the big banks go on an orgy of government-guaranteed borrowing and risky investment. From my last post you can see it going either way. Anti-capital fallacies just pour slops into the second trough.
Their argument:
Here’s what really went wrong in the fall of 2008… Regulators were in such a panic that they hastily increased banks’ capital requirements from 4% to 7%, without thinking through the long-term ramifications.
There are two ways for banks to raise their capital-to-asset ratios: by increasing capital or decreasing assets. Which is most likely during a crisis? Issuing new equity or bonds would be difficult under crisis conditions, so banks will instead shed risky assets. In late 2008 and early 2009 that meant a drop in lending to the private sector and a credit squeeze. As businesses repaid loans, new ones were not issued in their place and the quantity of money in the economy fell. That hit demand, spending and jobs, just as it had in the Great Depression.
What was the fallout? In the five years preceding October 2008, bank lending to the private sector had soared by more than 75%, according to Fed data, from $4.2 trillion to $7.4 trillion. In the five years after, bank lending stagnated, increasing by less than 10%.   
The stock of loans actually went down during the first two years of this period, the only time such a thing has happened on a significant scale since the 1930s. The reversal was most extreme for industrial and commercial loans, which plunged from $1.6 trillion at the end of October 2008 to $1.2 trillion two years later. 
…The blame for this credit crunch falls on the Fed, acting in concert with the Bank for International Settlement 
Let’s leave aside quibbling about the facts — just what capital requirement they are talking about, when it it, and so forth. Leave aside the great argument whether any of this even happened in the crisis — whether regulatory capital constraints were binding (the banks said no), and whether banks as a whole shed risky assets. Leave aside the “the quantity of money in the economy fell,” and ignore the graph below:

Consider the logic of the argument. A rise in capital requirements in Fall 2008, singlehandedly caused a “credit crunch,” and lending to “plunge,” and bank lending to “stagnate” for five years. Among other influences not held constant here, let us not forget the TARP, which, like it not (I don’t) gave the banks a massive shot of… capital.
That brings us to Mr. Kashkari’s proposal to further double capital requirements. What might happen if the Trump administration enacted his plan? Bank stocks would take another dive. They would find it impossible to raise new capital through equity or bond issues, so they would be forced to shed assets. As in 2009 and 2010, banks would refuse applications for new loans. They might go so far as to wriggle out of contracts for existing loans and ask for early repayment.
(Kashkari and a lot of others I might note — especially the courageous Admati and Hellwig, and on the political side Jeb Hensarling. )

Here you see the deep illogic of the oped: It concludes, from the assertion that banks in the middle of a once per half century financial crisis, cannot raise capital in a week by means other than selling assets (even if that assertion is true), that banks cannot over five years or more, of normal and healthy financial markets, raise adequate capital to bear the brunt of the next crisis without cutting lending.
Banks have many ways to raise capital in functioning markets, and even in relatively dysfunctional markets. Even in 2007, if memory serves me right (there was a Bloomberg.com article on this I can’t find right now, I welcome a source), banks raised something like a trillion dollars of new equity, in order to cover losses in their asset positions. When buyers come and take over a bank, that is an equity injection. Lehman itself was poised to be bought in this way, until UK regulators nixed the deal. Banks can reduce dividend payments, which increases the total value of equity, or big payouts to senior employees. If banks aren’t lending, in a functional regulatory market (not ours) new banks can IPO and take over their business. In two weeks, in the middle of a crisis? Maybe not. In five years? That does not follow.
Yes, in a city-wide conflagration, “Everybody run down to Home Depot, buy and install sprinklers,  and grab a carful of fire extinguishers” is not going to work. It does not follow that in the five following years a city code that requires sprinkler retrofits and fire extinguishers cannot stop the next fire from happening.
And really — after all the stress tests, after all the slow, modulated, carefully pre announced capital raises by the Fed and others, do you really think banks would be faced with an overnight, increase capital by tomorrow morning or else? I know regulators can be a bit thick at times, but not that much!
Banks have been required to hold more capital against their risky assets, in the belief that this would make them—and the economy—safer. 
Yes, dear sirs, and that is an entirely correct belief!  Deeply, Congdon and Hanke miss the point of capital: it offers superior returns on average, but takes the losses in a crisis without needing regulators to spot the crisis, prop up markets, inject capital, lend of last resort, bailout and so forth. It’s not just there to gum up the works! This is entirely missing in the article. Not enough capital did indeed cause the crisis. If banks had 20 percent capital going in, there would have been no crisis, and no bailouts, because no bank would have gone under.
Anytime a commentator writes “hold” capital you know poor logic is coming. Capital is a source of funds, not a use of funds. Capital is not reserves.
2017/03/capital-illogic.html