Sunday, December 2, 2012

Steve Hanke criticizes Basel III for the wrong reasons

A recent post on the Cato Institute blog by Steve Hanke paints a grim picture of the impact from increasing bank capital ratio requirements on the US economy. He compares the current situation to the Basel I accord that supposedly lost George H. W. Bush his reelection by squeezing the money supply and causing a recession (in the early 90s). And the upcoming Basel III is going to do the same.
Cato Blog: - While the higher capital-asset ratios that are required by Basel III are intended to strengthen banks (and economies), these higher capital requirements destroy 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 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 account for new shares. This reduces deposit liabilities in the banking system and wipes out money.
Theoretically that's correct. However, US banks have been well capitalized for some time now (see this post from almost a year ago). Therefore Basel III by itself is not going to force significant capital increases by US banks. This of course is not the case in Europe (see discussion) and elsewhere (for example in South Korea the impact will be significant).

The data in the US suggests that unlike in the early 90s, money supply continues to grow unabated. Most US banks are operating as though they are already under Basel III, even if the rules haven't been fully implemented. Therefore if there was an impact on broad money stock, we would have already seen it.

As discussed here numerous times, the issue with Basel III is the ridiculous complexity and numerous idiotic rules in which a small group of bureaucrats with little understanding of US credit markets decide what banks should and should not hold (see discussion here and here). This, combined with the somewhat arbitrary Volcker Rule will have unintended consequences (see discussion). Professor Hanke is therefore correct to criticize Basel III, but he is doing it for the wrong reasons. In the US it is not about bank capitalization these days as it is about terrible regulation.
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