A popular line of argument blames the lack of bank lending despite the Fed’s extended ZIRP policy on the impaired capital position of the banking sector. For example, one of the central tenets of MMT is the thesis that “banks are capital constrained, not reserve constrained”. Understandably, commentators extrapolate from the importance of bank capital to argue that banks must be somehow recapitalised if the lending channel is to function properly as Michael Pettis does here.
The capital constraint that is an obvious empirical reality for individual banks’ does not imply that bank bailouts are the only way to prevent a collapse of the monetary transmission channel. Although individual banks are capital constrained, the argument that an impairment in capital will induce the bank to turn away profitable lending opportunities assumes that the bank is unable to attract a fresh injection of capital. Again, this is not far from the truth: As I have explained many times on this blog, banks are motivated to minimise capital and given the “liquidity” support extended to them by the central bank during the crisis, they are incentivised to turn away offers for recapitalisation and instead slowly recapitalise by borrowing from the central bank and lending out to low-risk ventures such as T-Bonds or AAA Bonds. This of course means that they are able to avoid injecting new capital unless forced to do so by their regulator. Potential investors know of this incentive structure facing the bank and are wary of offering new equity. Moreover, injecting new capital into existing banks can be a riskier proposition than capitalising a new bank due to the opacity of bank balance sheets.
So the bank capital “limitation” that faces individual banks is real, in no small part due to the incestuous nature of their relationship with the central bank. But does this imply that the banking sector as a whole is capital constrained? The financial intermediation channel as a whole is capital constrained only if there is no entry of new firms into the banking sector despite the presence of profitable lending opportunities. Again this is empirically true but I would argue that changing this empirical reality is critical if we want to achieve a resilient financial system. The opacity of bank balance sheets means that even in the most perfectly competitive of markets, it is unlikely that old banks will find willing new investors when dramatic financial crises hit. However, investors most certainly can and should start up new unimpaired financial intermediary firms if the opportunity is profitable enough.
The onerous regulations and the time required to set up a new bank clearly discourage new entry – see for example the experience of potential new banks in the UK here. But even if we accelerate the regulatory approval process, the fundamental driver that discourages the entry of startup new banks is the Too-Big-To-Fail(TBTF) subsidy extended to the large incumbent banks that ensures that startup banks are forced to operate with significantly higher funding costs than the TBTF banks. This may be the most damaging aspect of TBTF – not only does it discriminate against existing small banks, it discourages new entry into the sector thus crippling the monetary transmission mechanism via the bank capital constraint.