On The Paradox of Excessive Bank Regulation

By webadmin on 03:26 pm Apr 15, 2011
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Steve H. Hanke

Since
the collapse of Lehman Brothers in September 2008, the Delphic
Oracles, politicos and chattering classes of all stripes have been
working overtime to make the world safe from banks and, yes, bankers.
From many quarters we hear the same refrains: “shrink the banks,”
“put the bankers in straightjackets” and so forth.

Although
less colorful, official pronouncements echo the messages heard on the
streets. For example, the U.S. Treasury’s Principles for Reforming
the U.S. and International Regulatory Capital Framework for Banking
Firms (2009) stated that “higher capital requirements for banking
firms are absolutely essential.” Not surprisingly, the other
twenty-six member countries of the Bank for International Settlements
in Basel, Switzerland agreed with the U.S. Treasury. In the interest
of making banks safer, Basel III was passed in September 2010. This,
among other things, will require banks in member countries to hold
more capital than under the prevailing Basel II regime.

But
Prof. Tim Congdon – the authority on broad money – convincingly
argues that Basel III qualifies as “overregulation.” Prof.
Congdon demonstrates that a paradox accompanies excessive bank
regulation. While the higher capital-asset ratios that are required
by Basel III are intended to strengthen banks (and economies), these
higher ratios destroy money. In consequence, higher bank
capital-asset ratios contain an impulse – one of weakness, not
strength; hence, the paradox of excessive bank regulation is
observed.

To
demonstrate why the paradox exists, we only have to rely on a tried
and true accounting identity: assets must equal liabilities. For a
bank, its assets (cash, loans and securities) must equal its
liabilities (capital, bonds and liabilities which the bank owes to
its shareholders and customers). In most countries, the bulk of a
bank’s liabilities (roughly 90%) are deposits. Since deposits can
be used to make payments, they are “money.” Accordingly, most
bank liabilities are money.

Under
the Basel III regime, banks will have to increase their capital-asset
ratios. They can do this by either boosting capital or shrinking
assets. If banks shrink their assets, their deposit liabilities will
decline. In consequence, money balances will be destroyed. So,
paradoxically, the drive to deleverage banks and to shrink their
balance sheets, in the name of making banks safer, destroys money
balances. This, in turn, dents company liquidity and asset prices.
It also reduces spending relative to where it would have been without
higher capital-asset ratios.

The
other way to increase a bank’s capital-asset ratio is by raising
new capital. This, too, destroys money. When an investor purchases
newly-issued bank equity, the investor exchanges funds from a bank
deposit for new shares. This reduces deposit liabilities in the
banking system and wipes out money.

As
banks ramp up in the anticipation of the introduction of Basel III in
January 2013, we observe stagnation in the growth of broad money
measures. Given the paradox of excessive bank regulation, this is no
surprise. As we can see in the accompanying table, the quantity of
money and nominal national income are closely related. Therefore,
overzealous bank regulations, such as Basel III, constitute bad
economic news because they drag down broad money growth and economic
activity.

To
appreciate just how broad measures of money have stagnated, and at
relatively low levels, we present the money growth rates for the
United States, the United Kingdom, Europe and Japan in the
accompanying chart. And if we want a more dramatic depiction of what
is occurring in the U.S. (where quantitative easing has been
improperly conceived and implemented) contemplate the sickly-looking
money multiplier chart. The Fed is getting very little bang for the
high powered base money it produces.

The
anemic money multiplier can be laid squarely at the feet of Basel
III, as well as new domestic bank regulations. When we move from the
international sphere of Basel III to the purely home-grown variety of
bank regulations, we find a real monster. This past summer, a
2319-page Dodd-Frank financial reform bill was signed into law by
President Obama. This law will be accompanied by a plethora of new
regulations and armies of new regulators. How many? No ones knows
because the complex rule-making process that is associated with such
a Byzantine law has hardly begun and will take years to complete.
Talk about generating unnecessary uncertainty!

President
Obama and Ben Bernanke, the Fed’s chairman, both champions of Basel
III and more bank regulation, would have us believe that a boom is
right around the corner. But, don’t hold your breath. Government
failure plunged the world into the greatest slump since the Great
Depression, and overzealous bank regulation – yes, another
government failure – has put a damper on broad money growth. In
consequence, we can expect a period of modest trend-rate growth, at
best. And that is just what the Federal Reserve Bank of Chicago’s
National Activity Index, which is made up of eighty-five indicators,
is signaling.

Steve
H. Hanke is a Professor of Applied Economics at The Johns Hopkins
University in Baltimore and a Senior Fellow at the Cato Institute in
Washington, D.C.