[OPE] John Kay on surplus capital

John Kay (FT journalist) has a smart little article "Surplus capital is not for wimps after all" (FT, October 21 2008). http://www.ft.com/cms/s/0/04767eee-9f71-11dd-a3fa-000077b07658.html Among other things, he writes (excerpt, for scholarly purposes):

"One consequence of the Basel agreements on capital requirements for financial institutions is that many of these institutions came to believe it was wimpish to hold more capital than the regulations demanded. There were superficially appealing financial arguments to justify that position. Surplus capital reduces return on shareholders' equity and acts as a drag on earnings per share. Analysts judge banks by these ratios. The rewards of senior executives were often tied to them. A bank might sell some branches, assisting the purchaser with a non-recourse loan, for which the borrower is not personally liable. At current rent levels and interest rates, the rent would service the debt. The financial effect of the transaction is that any future capital gain on the property is transferred from the bank to the buyer. At the same time, the capital base of the bank is reduced, impairing the security of depositors and lenders. But reducing capital is the point - the only point - of the transaction. Since the yield on property is less than the bank's return on equity, the return on equity is increased. I am not making this up. The executives who planned this and similar transactions were applauded for their financial acumen and focus on shareholder value. You can raise return on capital by increasing returns or by reducing capital. Reducing capital is easier. Such financial alchemy does not just apply to banks. You can increase earnings per share by increasing earnings or by reducing the number of shares. Reducing the number of shares is easier. The professor of finance can quickly pinpoint the fallacy in the surplus capital argument. Debt is cheaper than equity. But the cost of both debt and equity depends on their riskiness. Increasing the ratio of debt to equity makes both debt and equity riskier and raises their costs. So the gain from substituting debt for equity must be offset against the loss from increasing the long-run cost of both debt and equity. In an article that is still a classic of finance theory, Merton Miller and Franco Modigliani showed, 50 years ago, that in an efficient market the loss would exactly offset the gain.
There are a few complications. In particular, markets are not always efficient. But prices tend to revert to fundamental value in the long run. The mispricing of risk eventually reveals itself. As it has just done.
Banks would normally be wary of lending to someone whose liabilities were 50 times their net assets, but they happily lent to each other on that basis - until, one day, they stopped. If you want a one sentence explanation of the present crisis, that is it."

The wry moral of this story (worth reading as a whole) is that the banks can never have too much money, and thus, that surplus capital doesn't really exist.

I am a bit skeptical of the empirical validity of Modigliani's capital market idea as described, and of risk ideology - of course, in finance proper, risk-pricing has a very precise meaning, but how do we ever know what a risk is truly worth, other than what people are currently prepared to pay to insure themselves against it? For thousands of years, people faced the same risks without insuring themselves against it beyond ordinary behavioural precautions, and thus those risks had no particular economic value. "Mispricing risk" (overvalued risk or undervalued risk) just means that people are prepared to pay more or less for capital insurance than they did before, it's a "state of the market" kind of thing, which can be influenced both by (1) subjective perceptions, (2) the probability, possibility, type, incidence and frequency of objective risks incurred, and (3) the interaction between them.

It would be rather glib to say that if things stuff up, that "oh well, we mispriced the risk" (although bankers might say it, in a technical sense). "Fundamental value" can be specified in this theory only in terms of the capacity of assets to generate income or at least hold their average value, and the capacity to pay bills on time. The justification of capitalism in this case is that capitalists are risk takers, but their financial risk-taking in this case consists mainly of insuring themselves against risk through organisations which leverage the burden of the risk, not necessarily a lot of sturdy persons individually shouldering personal risk. Ordinary workers take great risks all the time for which they are not insured at all, because those risks are not even valued, never mind being able to pay the insurance necessary to safeguard against the risk. If they were comprehensively insured, capitalism would be impossible, the cost would be too great. At a certain point, therefore, risk ideology becomes banale - it is sort of like saying "life is a risk". Yeah.

Of course, in Marxian theory, "surplus capital" has a different meaning - it refers to that portion of resources which practically could be invested in job-creating production, but which isn't (in Japanese, it's sometimes called "Shikin", idle funds). The neoliberal expectation was that if investment capital was cheap to get, production would flourish and expand, and more jobs created. But in fact, a growing portion of those investment funds, being held largely by a small minority, hive off into a separate circuit of financial trade, for which the direct collateral is mainly already existing assets, not new production, meaning that, on the whole, output growth is far below what it could be, given the resources available ("capitalist production growth with the brakes on"). For environmentalists that might not be a bad thing, but for those whose material needs are not adequately met, it is a serious problem.

I suggested in previous posts some of the factors involved (profit rate differentials, rather lacklustre final demand growth, organisational aspects, the structure of finance itself, risk considerations etc.) but to ascertain the relationship between them in order to develop an adequate, integrated explanation would obviously require close attention to the empiria. As I am not a paid academic I cannot research this in depth at present. What John Kay doesn't explore is why the bankers stopped lending to each other - the gigantic global project to extract income from the trade in borrowed funds is premised crucially on trust, organisational power and market confidence; large default shocks create worldwide financial repercussions that not only create extra risk, but make risk difficult to assess; as confidence breaks down, the apples start to roll off the apple cart, so to speak.

The irony, as I mentioned before, is that the gigantic effort to insure ("securitize") the value of capital turns onto itself, it turns into its dialectical opposite, through the overextension of credit which it makes possible, thus exascerbating risk, rather than reducing it. It's like, the more anxiously capitalists individually try to hold on to their capitals, the greater the aggregate risk of losing part of their capitals' value. In the end, the profligate, prodigal capitalist calls on the government to insure and collateralize the business some more. Entrepreneurship is a noble endeavour, but simply extracting the most profit with the least effort under an insurance warranty, in the shortest possible time, does not really benefit society much at all. That sort of financial style ends up wreaking havoc. If in fact you create more overall risk by the procedure of "spreading the risks", you just make life for all more insecure. We are then dealing with a level of uncertainty that never existed before, but is purely socially constructed.

The more simplistic Marxist theory assumes that "capital" is just production capital (variable capital, constant capital and faux frais) but that is obviously not true; in the first place there's capital finance, commercial capital and capital reserves, but also, in rich countries at least, a much greater capital value exists outside production than is invested inside it. Perhaps a third of the working population there produces new material wealth, the rest are really conserving capital, operating its transfer or providing social services of various kinds. Therefore, to explain economic growth patterns in terms of the "expanded reproduction of production capital" (as traditional 1920s Marxist models do) is highly simplistic, simply because non-productive capital in all forms is a multiple of productive capital, and because it abstracts from the concentration patterns of capital ownership.

It is true however that ultimately the "real economy" (production of new goods and services) still underpins financial trade - among other things, in aggregate, you cannot constantly keep earning income from selling for more than you buy, without parellel net additions to the total stock of real assets occurring (the "value added" or surplus value lodged in products; the whole system is still based on capitalizing the value of unpaid surplus labour, the Mehrarbeit). You can do that only at the price of taking income from other people. Hence also the obsession with GDP as an indicator of productivity and net new wealth creation.

In reality, however, the GDP concept conflates the concept of capital accumulation with the concept of the creation of new value (the ambiguity of the concept of accumulation being, that accumulation could occur either by producing net new wealth (aggregate growth) or by redistributing existing wealth in some way (no aggregate growth)). Both obviously occur at the same time, that's what makes it so complex.

These days, this conflation becomes of critical importance, insofar as the trade in already existing assets begins to outpace the trade in newly produced products - in which case an extensive circuit of income & expenditure emerges that simply fails to be captured by the GDP concept. By the time that the statistically defined "net output" of financial services itself rises to something like a third of GDP, we have to think again about what is really being measured here (I still intend to write that up some time in a technical article). Fashionable Leftists complain the GDP doesn't measure wellbeing, but that is like saying that a thermometer does not measure gravity. Big deal. That sort of critique is shallow, in particular because the wellbeing of a society vitally depends on the creation and distribution of new wealth, commensurate with population growth.

Jurriaan

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Received on Wed Oct 22 17:06:01 2008