1. Comments on “Credit Allocation, capital requirements, and procyclicality” by Esa Jokivuolle and TImo Vesala

2. Date Arial Bold 10pt Introduction This is a fascinating paper, and of high technical quality. That is no surprise, coming as it does from the Bank of Finland “stable”. But it reaches a surprising conclusion, contrary to much recent and widely accepted literature. It demonstrates the possibility that the much-vilified Basle II regulation of banks will not amplify the cycle in bank lending and the economy, and will, in a process interlinked with that which reduces cyclicality, increases the efficiency of bank lending. This I have the pleasure of discussing a highly skilled paper which reaches a novel and unexpected (beyond the boundaries of Basle) conclusion.

3. Date Arial Bold 10pt Introduction I will first briefly summarise the main lines of argument. Under Basle I all loans attracted the same capital weighting. Under Basle II more risk implies more capital. This, the paper suggests, means that Basle I gave a subsidy to risky loans relative to less risky ones, for risks were not reflected in requires capital. So allocation of capital to investment projects will improve. At first glance this might increase procyclicality (by having bigger write-offs in downturns), but as they point out this conventional conclusion rests on a failure to note that these bigger write-offs will be offset at least partially by a smaller portion of assets being risky. The story makes intuitive sense, and is supported by the analysis.

4. Date Arial Bold 10pt Some Key Factors Let me now turn to some key aspects of the model. The world is one where entrepreneurs of an unobservable type – a feature I emphasise because of it is of great importance later – choose between high and low risk investments. Success depends on both the entrepreneur and the investment, and this dependence on the entrepreneur is the greater in high risk investments. In such a world the projects, the riskiness of which banks can observe, determine the capital allocation.

5. Date Arial Bold 10pt On the basis of their analysis of this world, the authors conclude: “Basle II is a stronger candidate for being better for social welfare because, in the light of our model, it can correct the fundamental overinvestment problem stemming from asymmetric information, which Basle I only makes worse” (p18) AND “This suggests that Basle II does not necessarily lead to exacerbation of macroeconomic cycles because the reduction in the sub optimally high proportion of high-risk investments, which may have resulted under Basle I, should mitigate the cyclicality of bank lending over the business cycle.” (p19)

6. Date Arial Bold 10pt Concerns There seems to be to be absolutely nothing wrong with the argument of the paper. But I am far from believing its conclusions. My concern arises because the authors have not thought about what the core functions of banks were or indeed are, and are thus writing about banks as if they were, I shall suggest, no more than markets for saving and investment. The point can be shown by a brief discussion of how banks evolved. It is generally accepted that (modern European) banking evolved first from the activity of being a goldsmith and then from that of money changing, and that this evolution took place in the early Middle Ages (1000AD to perhaps 1200AD). In those years the role of barter in trade appears to have started to decline fairly sharply, and there was increasing use of coins. (Banknotes came later).

7. Date Arial Bold 10pt Coinage was, however, distinctly imperfect. Even if from the same mint coins could vary in appearance, weight and quality of metal. Money changers thus had an important role, not just in appraising coins but in storing them and ensuring a supply of generally acceptable ones. When a merchant was paid in coins, these could be deposited with the money changer who then credited them to the merchant’s account. The money changer would then supply money to the merchant if he needed it to make a payment, or, if he were paying a merchant who had an account with the same money changer, would simply debit one account and credit the other. Thus the deposit side of what we call banking emerged. The lending side developed in the following manner. The money changer now had a store of money And over time it was learned through experience that the occasions when this entire store was needed at once were very rare indeed. Accordingly, some of the store was lent out. Thus we got fractional reserve banking and the connection of deposit taking and lending in one institution. That is very much a standard story, found in many histories of money or banking.

8. Date Arial Bold 10pt In his 1998 paper Rajan added a further step, and one which is very important for the present analysis. He points out that banks then did not make long term loans, but rather allowed depositors to ‘overdraw’ their accounts. These overdrafts were available more or less on demand, and were used to finance trade. It was natural to combine this form of lending with deposit taking, for both required an inventory of cash, and both required an estimate based on experience of when there would be net demands for cash. He also argued that it is natural, in the sense of economising on information, to make loans to depositors, for by watching a borrower’s deposit account the money changer obtained information about the health of the business to which funds were being lent. By that route emerged, then, the fractional reserve bank which took deposits and made loans. Thus were the two activities carried out by the same firm. The simultaneous conduct of borrowing and lending business can allow “diversification across the liquidity demands of depositors and borrowers”. (Kayshap, Rajan and Stein 1998). This allows expansion, and thus the wider spreading of the relatively fixed costs of security arrangements and agreements for borrowing from other banks when necessary. At the same time, of course, banks started to act as delegated monitors, and to provide a measure of liquidity insurance.

9. Date Arial Bold 10pt Although these are sometimes suggested as alternative explanations for the development of the form of banking to which we have become accustomed, they are of course automatic consequences of the development of banks along the lines set out so far. They are complements, and neither competitors nor substitutes. Thus to conclude this section, the core banking firm is one which takes deposits and makes loans. Now, note that these banks make loans on the basis of knowledge of their customers. This is close to the polar opposite of the assumption of the present paper, where banks know about the projects to be undertaken by their customers, but not about the customers. In fact, these banks are more like markets – for they have public but not private information. The moment we grant banks knowledge of their customers, they are perfectly capable of adjusting either capital charges, or interest rates, or amount lent as a proportion of the collateral (if there is any) to reflect the risks. They do not need Basle to do it for them. Where does this lead?

10. Date Arial Bold 10pt Are Bankers Stupid? I put the question thus to highlight two matters. A legal or regulatory minimum is not a working minimum – if you can not go below it, then you apply whatever capital you need to it in addition. Further, Basle II can not possibly allow for the kind of private information that bankers have about many of their customers – simply because the enforcers of the rules can not observe that information. So bankers will hold a cushion above the minimum, and the size of this cushion will depend in part on what they know about their customers and in part on what they know about the projects. Since they were doing that anyway – unless they were stupid – what does Basle II do? It makes banks hold more capital to the extent that it raises capital requirements overall, but it is not clear that it does. Note that the implementation of the “advanced approach” allowed Northern Rock to reduce its capital.

11. Date Arial Bold 10pt Can we believe this paper? The answer seems to me that we can not – we can not say it is wrong (analytically it is not,) but it rests on implicit assumptions which mean that its policy conclusion can not be accepted. Of course, neither can it be rejected. For the decision to accept or reject rests on private information on the intelligence of bankers. Nor, unfortunately, can we say that Basle ii will ensure a substantial increase I the capital of the banking system. Accordingly, then, the praise Basle II receives in this very interesting paper is premature. Geoffrey Wood Professor of Economics, Cass Business School London 22nd April, 2008