Vince Cable gets it wrong on capital and lending

Vince Cable is one of the biggest brains in UK Government. He’s a trained economist and was one of the few MPs who warned, well ahead of the crash, that bad things were afoot in the UK economy.

So it pains me to have to say this but I’m afraid that in his extraordinary attack on the Bank of England this morning, the Business Secretary is simply wrong. To make matters worse, he also seems to be labouring under a delusion which has been largely spun by the banking lobby. It is this: that asking banks to raise extra capital will in turn mean they have less money left to lend out to small businesses.

The notion, which sounds intuitive but is nonetheless wrong-headed, is that capital is a kind of pot in a bank’s balance sheet, and that compelling a financial institution to leave more in there will mean it consequently has less money to hand out to the businesses and households in this country. A brief glance at a bank’s balance sheet will show you as much.

A bank has two sides to its balance sheet: stuff it will at some point have to pay back to other people (liabilities) and stuff other people will have to pay back to it (assets). The key thing to remember is that these two sides must equal each other at all times.

Now, those assets include loans to businesses and households, cash in its vaults and investments. Liabilities include all the stuff that funds the bank: deposits from you and me, debt borrowed from investors and, of course, capital – shares or equity. And the reason capital is so important is because, unlike debt or deposits, you don’t get into Cyprus-style scrapes when you make losses and need to make yourself good somehow.

As you can see, capital is not a money box from which a bank gets the cash to lend to businesses. It’s in an entirely different part of the balance sheet. Capital is, when it comes down to it, money a bank has persuaded investors to give it, which always sits there in its balance sheet as an insurance policy against collapse.

Now, that’s not to say there isn’t an indirect connection between the amount of capital a bank needs to raise (which is what the Bank of England is calling for today) and the amount it tends to lend out. It’s just that it’s far less direct than is usually made out.

Consider why: if the regulator wants a bank to have a bigger percentage of capital on its balance sheet, one way of hitting that target is to shrink the assets side of its balance sheet while simultaneously shrinking the debt it’s borrowing or the deposits it’s taking (both of which are, like capital, on the liabilities side).

However, as you can judge from the paragraph above, that’s hardly the simplest way of doing it. A far simpler way of doing it would be either to a) raise more shares from investors, b) pay out less to investors or employees, since retained earnings also count as capital. Alternatively c) you can get rid of some of your investments; the big banks are already in the process of doing this – selling off US arms and so on.

The point, though, is that there are plenty of options at the banks’ disposal, of which shrinking lending is only one, and hardly the most direct or obvious one. Now, there is an open question about the extent to which the falls in business lending are due to a lack of demand from businesses or a lack of supply from the banks.

But, to get back to my initial point, capital is not a magical money box. It’s an investment in a bank. The Bank wants banks to raise more of it; they are trying to avoid doing so. Simple as that.