Controls On Bank Capital Are - Yet Again - Exposed As Worthless

A Wall Street Journal headline from last Friday, though all too predictable, revealed yet again how very pointless are bank-capital requirements, naïve regulations in the form of the much vaunted "Volcker Rule", and Fed policy more broadly.

Needless to say, it seems politicians, regulators, central bankers, and politicians on the left and right are primed to be taught once again that the U.S. economy is not an island unto itself, and as such, how worthless will be their attempts to regulate economic activity, abolish failure, and "contain" alleged economic calamities that merely show capitalism to be working.

The Journal headline that said it all was, "Banks Find Loophole on Capital Rule", and it's something that was long predicted in this and other columns. To foresee it was in no way visionary, rather the prediction had to do with the simple reality that money is fungible, and attempts to restrain capital flows will invariably lead to sharp minds navigating around those barriers.

In this case, U.S. branches of foreign banks, frustrated by capital requirements that weigh on profitability, are not surprisingly changing their legal classifications in order to avoid more stringent lending rules set by the Dodd-Frank law. Had politicians and regulators done their homework, they could have foreseen this. Capital reserve requirements have been tried before, and they failed.

As Margaret Thatcher's Chancellor of the Exchequer Nigel Lawson noted in his autobiography, The View From No. 11, despite reserve requirements in the late ‘70s meant to hold down lending, "If mandatory reserves exceeded the amount that banks wanted to hold voluntarily", they would simply "redirect the lending via offshore subsidiaries" beyond the purview of UK regulators. Much the same, if lending limits at London banks were troublesome, those same London banks would allow their Paris branches to bid on their reserves after which bank branches in Paris would lend pounds to UK residents.

Though England is an island, the market for British pounds isn't isolated to the island, so any attempt by UK authorities to "tighten" access to pounds was made up for in non-British markets for the same currency. As Lawson found, from October of 1979 to June of 1980, the Euro-Sterling market grew from 14 billion pounds to 23 billion in response to local - and very naïve - efforts to tighten in England.

Something similar occurred in the U.S. back in the ‘70s and early ‘80s when capital requirements were foolishly foisted on U.S. banks. As economist Marc Miles noted in his essential book, Beyond Monetarism, between December 1978 and June 1980 the Fed increased marginal reserve requirements on certificates of deposit, but rather than making credit scarce, it merely boosted the market for commercial paper. Absent commercial paper, reserve requirements laid down on U.S. banks were and remain easy to get around given the existence of unregulated, offshore banks that don't fall under the myriad rules and regulations imposed on those located in these fifty states. See England, once again.

To this day, it's said that the Volcker Fed "tightened" monetary policy in the late ‘70s and early ‘80s, but the reality was quite different. Indeed, while the Fed can impose reserve requirements on U.S. banks all the while raising interest rates to reduce U.S. bank reserves, it doesn't control the global market for dollars. In short, if the Fed drains U.S. banks of dollars, other sources of dollar credit will perk up.

That's exactly what happened early on in Volcker's Fed tenure. With the Fed "tight", the Eurodollar market became active on the way to Eurodollars amounting to 59% of M1. The Fed can drain the pond that is the U.S. of dollars, but if so, dollars from outside the U.S. will refill the pond.

At present the Fed is flooding U.S. banks with unwanted dollars in the naïve belief that "money" is the source of economic energy, but rather than increase the "supply" of money, the Fed's overshoot merely means that non-U.S. dollar markets will be less active in supplying the U.S., not to mention that in a world where 2/3rds of all dollars are overseas, many will migrate away from the U.S.

Money supply in the States, far from something the Fed can increase or decrease, is a function of economic activity. A weak dollar is anti-economic growth, so at present money supply is paradoxically low precisely because the dollar is weak. If Treasury ever seeks a stronger dollar on the way to increased investment in economic activity, money supply will paradoxically increase. But with numerous markets for dollars in existence around the world, this is hardly something the Fed can manage.

Back to the banks, the fungible nature of money means that reserve requirements will always be easy to get around, and at best, it means as this column has long maintained, that the mythical notion of "systemic risk" will simply shift elsewhere. Worse, assuming reserve requirements actually cause U.S. banks to keep more capital in reserve, this will merely reduce their profits on the way to their irrelevance a la the S&L's in the 1970s. How odd that the very requirements meant to keep banks from taking major, insolvency inducing risks will, if stringent, make them less profitable on the way to another kind of insolvency. See, once again, the S&Ls in the ‘70s.

The modern "Volcker Rule" means much the same. The naïve in our midst think it's a proper rule for reducing the risk profile of banks, but the greater truth is that banks take major risks precisely because they're profitable. To regulate this activity away is to regulate away profits; that or banks will once again shift these activities to entities not under the thumb of Washington. At best, banks totally hamstrung by the Volcker Rule will be made irrelevant on the way to the kind of failure that rules such as this were supposed to ease.

Not mentioned enough is that risk-taking is a good thing, and if it leads to financial institution bankruptcy, that too is a positive. It means capitalism is working, that the assets of the failed institution will quickly reach better managers, plus today's and tomorrow's bankers will have past examples of what not to do to draw on.

In short, the only regulation so far not mentioned by the political and economic establishment is the only one that would actually work for banks, and all other economic entities: Let them fail. Absent this most basic of rules meant to concentrate the minds of the nation's financiers, all attempts to fix the banking system will be discredited given the ease with which money and credit slip through sieve-like "regulations".