Bank Capital Adequacy Ratios - Basel

[flow5]

The Fed's changed in many ways. The Fed's not more translucent, it's more obtuse & opaque. Maybe most perverse is that it now inadvertantly restricts money growth using capital requirements (CB's assets) & not reserve requirements (CB's liabilities).

E.g., under Basel iii, as interest rates rise, banks will automatically have to mark-to-market (their securities held-to-maturity), increasing the amount of regulatory capital they need.

Under Basel iii, an increase in bad debt could force bank credit contraction. The "trading desk" doesn't have the current data which is necessary to calculate risk-weighted capital/asset ratios (ratios change when the quality & quantity of the CB's assets change).

Call reports won't provide accurate & timely asset data. Not even FDIC bank examiners (using FASB guidelines) can accurately assess a bank's financial condition (unlike the liability side of a CB's balance sheet).

Contrary to Dr. Milton Friedman, legal reserves were not a tax. On the other hand capital requirements negatively impact both the CB's earnings & CB credit creation.

[flow5]

Bank capital/asset ratio requirements are too high. It takes an additional $166,667 of new income-earning assets in order to offset a $5,000 charge off to bad debt (using a 3% profit margin).

Loan-losses are first written off against a commercial bank's undivided profits account. The undivided profits account consists of accumulated net income (retained earnings) before any dividend payouts or transfers to the bank’s paid-in surplus account.

Retained earnings add to the owner’s equity (bank capital) on the balance sheet. Bank capital is calculated from the residual of total assets minus total liabilities (the creditor’s margin of protection if a bank’s assets had to be liquidated in order to discharge its outstanding claims).

But any hit to regulatory capital affects a bank’s legal lending capacity. Lending is constrained by how much capital a bank needs for any particular investment. Capital ratios (capital to risk-weighted assets) affect the bank’s rate of return. Bank income varies according to each asset class’s capital requirement.

When bad debt wipes out the associated assets & liabilities (& regulatory capital), it lowers the bank’s lending capacity disproportionately (i.e., the volume of additional earning assets/retained earnings required to offset bad debt, or to replace bank capital), is disproportionately related to the bank’s loan loss (or allowance for bad debt).

The FRBNY's "trading desk" can inject or drain bank liquidity (legal reserves), but adequate levels of bank capital can only be monitored & adjusted by the responsible bank holding company.

[flow5]

Bank capital didn't change on "Black Monday". Bank capital didn't change on 2/27/2007 (Bernanke told the House Budget Committee he could see no single factor that caused the market's pullback a day earlier"). Bank capital didn't change on 5/6/2010 (flash crash). But legal reserves changed significantly on all 3 market crashes.

Those who profess that reserves aren't binding have never looked at the data:

"Bank lending is not reserve constrained" - MOSLER
"Banks are never constrained by reserves" - HARRISON
"Banks are never reserve constrained" AUERBACH
"bank reserves does not constrain the expansion directly" - BIS
"Bank lending is not “reserve constrained”" - MITCHELL
"Banks are never reserve constrained" - ROCHE
"banks are not reserve-constrained" - WRAY

[flow5]

x