Ackermann and Dimon 1; Bernanke and Geithner 0

My last blog on bank capital requirements concluded that the push to implement Basel III, which mandates increases in bank capital-asset ratios, is a deadly cocktail to ingest in the middle of an economic slump.

Shortly after, the Chairman of Deutsche Bank Josef Ackermann weighed in during a Frankfurt speech with a blistering attack on raising capital-asset ratios in the middle of a slump.  He was armed with heavy artillery – namely, “The Cumulative Impact on the Global Economy of Changes in the Financial Regulatory Framework,” a 123 page Institute of International Finance report that was hot off the press.

Today, the Financial Times reports that Jamie Dimon, Chief Executive of JPMorgan, has gone even further than Ackermann.  Indeed, Dimon suggests that the new Basel III capital requirements are “anti-American” and that the U.S. should consider pulling out of the Bank for International Settlements in Basel, Switzerland.

Both Ackermann and Dimon are right. The cheerleaders for the imposition of higher bank capital requirements in the middle of a slump – like U.S. Treasury Secretary Timothy Geithner and Fed Chairman Ben Bernanke – are wrong.

We can demonstrate the validity of this conclusion with ease.  Higher capital-asset ratios are “deflationary.”  If we hold the level of a bank’s capital constant, an increase in its capital-asset ratio requires that the level of its assets must fall.  This, in turn, implies that the banking system’s liabilities – demand deposits – must contract.  Since the money supply consists of demand deposits, among other things, the money supply must, therefore, contract.

Alternatively, if we hold assets constant, an increase in the capital-asset ratio requires an increase in capital.  This destroys money.  When an investor purchases newly-issued bank shares, for example, the investor exchanges funds from a bank deposit for the new shares.  This reduces deposit liabilities in the banking system and wipes out money.

It’s no surprise that Sir John Hicks – a high priest of economic theory and 1972 Nobelist – thought there was nothing more important than a balance sheet.

If Geithner, Bernanke and other members of the official chattering classes insist on higher bank capital-asset ratios, the U.S. might, unfortunately, revisit 1937.  It’s time to listen to Ackermann and Dimon.