Bank capital and the new credit multiplier

The ongoing debate on the money supply process (the relationship between bank loans and bank deposits) has recently been enriched by introducing the importance of equity capital (see Lavoie, 2003; Karagiannis et al., 2011, 2012). The importance of bank equity for book (loans) expansion and consequently for financial stability was first identified by the Basel Committee in 1988, then by Basel II agreements (2006) and more recently by the Basel III (2011) capital requirements framework.

The reason for studying the linkages between bank equity and bank lending lies mainly in its possible importance as an alternative monetary policy vehicle. This issue emerged as a by-product of the liberalization process of the banking industry around the world, which induced a lending boom-bust cycle and had to be restricted for financial stability reasons (Goodhart et al., 2004), as well as adding to banks' insolvency risks. Consequently, the Basel Committee issued a number of directives for G10 banks (Basel Committee on Banking Supervision, 1998) that had two supplementary aims: first, to specify the different categories of collateral attached to different bank loans, actually calculating the "net" exposure; and, second, to attribute the appropriate weight to these (collaterally adjusted) exposures.

These directives aimed at reinforcing the Capital Adequacy Ratios (CARs) imposed on the banking sector. However, some years later, the Basel Committee was compelled to issue revised directives (see Basel Committee on Banking Supervision, 2006) in order to describe bank exposures in more detail; these directives were further revised more recently (see Basel Committee on Banking Supervision, 2011).

The CAR regulation follows the Basel II and III mandates, in order to determine the banks' actual loan exposure (for instance, equity must be at least equal to 8 per cent of the bank's loans). CAR is used by the central bank to control the supply of bank loans. Further, monetary authorities have the choice of changing either the CAR percentage or the equity definitions (Tier I, Tier II, and so on). Consequently, CARs act as the "new" credit multiplier and follow the orthodox school of economic thought, which argues that "liabilities create assets" in the banking system. In a way, this new multiplier undermines the traditional role of minimum reserve requirements.

Post-Keynesians, however, have argued that the emergence of this "new" multiplier should be perceived in reverse; that is to say, equity is the result of bank lending. If loans are performing and generate profits, then equity (retained earnings) will be generated, too. According to this alternative view, in the banking sector "assets create liabilities".

When banks' profitability becomes marginal or huge losses are reported (such as in the global financial crisis that burst in 2008), a shortage of equity will occur. As a result, this response of the central bank and the (fiscal) authorities, in order to provide the neces- sary equity to banks, becomes vital for the survival of the banking sector as a whole. In this case, the central bank functions as a "lender of last resort" in terms of bank capital provision.

Economists argue that the willingness and effectiveness of such monetary policy reac- tions are of utmost importance, as they can, in theory, affect the direction of the flow in the "new" multiplier. As such, there are theoretically three alternative outcomes regarding the equity's multiplier direction:

(1) First, banks' equity may determine the banking book portfolio (loans). If this causal relationship is accepted, then the equity's multiplier is operative and in line with the mainstream approach.

(2) Second, if the banking book portfolio (loans) causes equity, then the equity multi- plier is operative, but in reverse. In this case, "banks extend credit, creating deposits in the process, and look for the reserves [now equity] later" (Holmes, 1969, p. 73). As a result, the post-Keynesian horizontalist view prevails in the money supply process.

(3) Third, one can assume that there is a two-way relationship between bank equity and the banking book portfolio. If this hypothesis is verified, then equity "causes" loan expansion and, at the same time, loans create equity. A possible feedback relation- ship between bank loans and bank equity lies within the structuralists' framework of analysis.

Overall, the importance of bank equity in the bank lending process signifies a new form of credit multiplier in monetary theory. In a way, this new multiplier undermines the traditional role of minimum reserve requirements. Further, the operational capability of this "new policy vehicle" is not given. It mostly depends on the way it intervenes in the financial system, thus raising a crucial question: is banks' equity capital exogenously determined by monetary authorities, is it credit driven and generated by banking profit, or is it a structural product of both forces? The answer to this question links directly to the traditional dispute between neoclassical and post-Keynesian views on the "nature" of the money supply process.

See also:

Bank deposits; Basel Agreements; Capital requirements; Collateral; Financial instabil- ity; Lender of last resort; Money and credit; Money multiplier; Money supply; Reserve requirements.