The real special thing about banks

Every once in a while it’s worth reminding ourselves what banks are here for. Worth it because since the crash there has been so much nonsense written by every type of commentator on just this subject.

The real special bit about banks, in the context of macroeconomics and global commerce, is that they take relatively small pools of cash each from large numbers of customers who wish to have instant access to it, and turn them into larger pools of cash that other customers wish to borrow for much longer periods of time. No other type of institution offers this “maturity transformation” service.

The instant access bank deposit is one of the unsung heroes of global economic development, because it has enabled world commerce to expand exponentially. The money transmission account or “checking account” is one of the world’s greatest and most influential inventions.

Customers value highly the existence of the instant access bank deposit, a product synonymous with cash itself. Bank accounts are near-money products.

Now let’s turn to bank regulatory capital. A generally accepted statement of fact is that the more capital a bank has, the safer it is. This is because capital is able to absorb losses arising from defaults by a bank’s loan customers.

But what about the oft-repeated complaint that if we raise minimum required capital levels, we restrict the bank’s ability to lend more?

This is an odd comment. A bank’s capital is a liability, not an asset. It isn’t “set aside” by the bank, as cash that would otherwise be used to make loans.

It is simply another form of funding for the bank. A bank can fund its assets with debt (customer deposits, funds raised in the wholesale money and capital markets, and so on) and equity (its own funds, or “capital”).

So if we raise capital requirements, we make banks safer but we don’t restrict their ability to lend money. There is a paradox here: corporate finance 101 dictates that we don’t invest capital in risk-bearing assets, rather we place it in risk-free investments and use the debt part of the liabilities base to invest in risky assets.

I believe in this philosophy, for a number of reasons. That said we could still use part of the capital base to fund risky loans, if we wished to.

In fact having more capital makes the bank safer and so we are theoretically able to use it to make more risky loans, and also by extension hold a smaller part of the balance sheet as liquid assets.

The need to ensure the bank remains “liquid” at all times will dictate that some assets on the balance sheet must be risk-free and truly liquid, but the higher the share of the bank’s funding that is composed of equity, the lower this liquid asset portion, in theory, can be. (This is the argument advanced recently by the Bank of England).

What some people are really concerned about here is leverage. The more a bank’s assets are funded by debt, the higher “return on capital” it makes.

So this is attractive for shareholders in the bank. But we shouldn’t confuse that with the idea that more capital means less lending.

A balance sheet has to balance, after all – whatever capital a bank has, the other side of the balance sheet is comprised of assets and that capital will be funding it.

Now back to the value of the deposit account. The population as a whole has great need for the savings deposit product, it is indispensable to the modern economy and modern commerce.

If we increase the share of the bank balance sheet that has to be funded by equity, rather than debt, we reduce the availability of the deposit product to the economy as a whole. At the macro level, banks would require customers to hold more bank equity, which is a riskier investment, and less in deposits.

That’s something to bear in mind as regulators raise bank minimum capital requirements worldwide.

It’s not exactly a fine line as such, but everyone from practitioners to policymakers should be aware of the role of bank capital and what banks are actually here to do. They are here to provide the essential function of maturity transformation.

The lobbyists have got it wrong: raising capital requirements isn’t bad for customer lending, far from it. But it may have an unintended negative consequence on the availability of deposits.

If this falls (and, if all else stayed the same, then raising capital requirements would indeed reduce the availability of the deposit product, almost by definition), then customers will have a smaller-size home for their savings and be holding a larger share of riskier bank equities.

The last thing we want is for customers to start turning to the shadow banking system to meet their deposit needs. We need to be mindful of the potential of higher regulatory capital standards to change the overall funding mix, and how this impacts customers.

Everyone loves a basic bog-standard bank account.