Hyun Shin’s Metaphorical Case for More Bank Capital – Real Time Economics

Metaphors matter, and they seem to matter particularly in shaping the debate over regulation of banks.

Hyun Song Shin , the Princeton University economist who is on leave to head research at the Bank for International Settlements, offered a clever one at the European Central Bank’s recent forum in Sintra, Portgual.

His point was that stringent, sensible financial regulation is important not only to maintain financial stability, but also for nurturing lending and prosperity.

In Shin’s metaphor, bank equity — the shareholders’ investment — is the foundation of the building.  Bank lending is the building itself.  Leverage — the extent to which the bank relies on borrowed funds — is the height of the building.

When an economy is growing, a bank adds floors on the same foundation.  The lower floors are loans made to the most credit-worthy borrowers; the higher floors, the riskier borrowers. If the bank adds too many floors on the same foundation — that is, if it borrows more and more to make more loans without adding to its equity – there’s a rising risk of collapse.

At the ECB conference, Shin showed this photo of what once claimed to be the world’s tallest single-family wooden house in Arkhangelsk, Russia.

In boom times, it’s easy to add more floors. But dismantling the building in a downturn is hard — and painful.  Small businesses and others who rely on bank loans get squeezed.

Most importantly, he said, anything that chips away at the foundations of the building exacerbates the economic pain. Yet this is exactly what authorities allowed during the early stages of the financial crisis when they permitted banks to continue to pay dividends.

Shin has been making this point for years, as recorded in a conversation I had with him for a Capital column shortly after the collapse of Bear Stearns in March 2008.

A bank’s equity – sometimes called its “capital”– serves a very important function.  To mix metaphors for a moment, equity absorbs losses when the loans a bank has made aren’t paid back. A bank that has too many bad loans can deplete its capital altogether. It’s then insolvent. It either goes out of business, is taken over by the deposit insurance authorities or, particularly in a panic, is bailed out by the taxpayers. One response to the global financial crisis has been to require banks to hold more capital so that taxpayers are less likely to get stuck with the tab.  Shin is arguing that’s not the only reason to conserve bank capital in a crisis.

And about that house?  Shin didn’t take the metaphor to its logical conclusion.  The house was condemned as a fire hazard, mostly pulled down and what was left was destroyed by fire.

2 June 2014 | 10:00 am – Source: blogs.wsj.com

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