Banking on Change

Are banks the problem or the solution?

Up until now, employment growth has been abysmal. And most jobs are created by young firms. But young firms have a hard time expanding, so they need bank loans. And bank loans are hard to get these days. The banks have all been told that they need higher capital ratios, and there’s two ways to do that: issue stock, diluting existing shareholders, or shrink the balance sheet, which temporarily reduces earnings. Hmmm: which do you think shareholders would favor?

The fact that higher capital ratios at the banks means slower loan growth and persistently high unemployment is one of the second-order effects that the current drive for safer banks is going to have. I’m not arguing that capital ratios should be lower—indeed, the failures of Bear Stearns, Lehman Brothers and MF Global were primarily the result of risky bets made with excessive leverage that went wrong. And you can’t legislate away mistakes.

But the pathway to increased prudence is important. If regulators demand more capital too quickly, the resulting financial deleverage is likely to slow or shrink money growth and hobble the economy. But if no improvement is demanded, successive failures like MF Global will cause us to question if we learned anything from the financial crisis of 2008.

There’s no free lunch. Increased financial prudence means a slower economic recovery. It’s too bad most politicians and regulators don’t get this.

Douglas R. Tengdin, CFA
Chief Investment Officer
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