Every once in a while, it's worth reminding ourselves what banks are here for. Worth it because since the crash there has been so much nonsense written by every type of commentator on just this subject.
The real special bit about banks, in the context of macroeconomics and global commerce, is that they take relatively small pools of cash each from large numbers of customers who wish to have instant access to it -- and turn them into larger pools of cash that other customers wish to borrow for much longer periods of time.
No other type of institution offers this "maturity transformation" service. The instant access bank deposit is one of the unsung heroes of global economic development, because it has enabled world commerce to expand exponentially. The money transmission account or "checking account" is one of the world's greatest and most influential inventions.
Customers value highly the existence of the instant access bank deposit, a product synonymous with cash itself. Bank accounts are near-money products.
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Now let's turn to bank regulatory capital. A generally accepted statement of fact is that the more capital a bank has, the safer it is. This is because capital is able to absorb losses arising from defaults by a bank's loan customers. But what about the oft-repeated complaint that if we raise minimum required capital levels, we restrict the bank's ability to lend more?
This is an odd comment. A bank's capital is a liability, not an asset. It isn't "set aside" by the bank, as cash that would otherwise be used to make loans. It is simply another form of funding for the bank. A bank can fund its assets with debt (customer deposits, funds raised in the wholesale money and capital markets, and so on) and equity (its own funds, or "capital").
So if we raise capital requirements, we make banks safer but we don't restrict their ability to lend money. There is a paradox here: corporate finance 101 dictates that we don't invest capital in risk-bearing assets, rather we place it in risk-free investments and use the debt part of the liabilities base to invest in risky assets. I believe in this philosophy, for a number of reasons. That said we could still use part of the capital base to fund risky loans, if we wished to. In fact having more capital makes the bank safer and so we are theoretically able to use it to make more risky loans, and also by extension hold a smaller part of the balance sheet as liquid assets.
The need to ensure the bank remains "liquid" at all times will dictate that some assets on the balance sheet must be risk-free and truly liquid, but the higher the share of the bank's funding that is composed of equity, the lower this liquid asset portion, in theory, can be. (This is the argument advanced recently by the Bank of England).
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