Models and Agents teach(es) us about Bank Capital

She writes:

So the first blunder comes early on when Greenspan talks about what he sees as a virtuous circle of rising stock markets, leading to improved credit conditions, higher lending and the resumption of economic activity… which in turn supports higher stock prices and so on.

While the idea that improved confidence can generate a virtuous circle has merits, what is questionable is Greenspan’s road to get there: The “newly created equity” in banks’ balance sheets as the prices of banks’ stocks go up.

Well that’s plain wrong. Regulatory capital, which is what matters for a bank’s ability to increase its lending, is not marked to market but at the price paid up originally to purchase equity in a bank. (Regulatory capital also includes other stuff, like retained earnings, which again are not marked to market but at the price when they were booked).

In other words, the increase in stock prices does NOT provide a “capital buffer that supports the debt issued by financial and non-financial companies” and does NOT “supply banks with the new capital that would allow them to step up lending.”

If there is one way higher stock prices help is if banks actually see it as an opportunity to raise new capital and expand their operations. Indeed, some banks have done so recently, but the main motivation was their urge to pay back the TARP money and rid themselves of the government’s watch. So new private capital replaced old government capital, without a meaningful improvement in banks’ ability to lend.

The problem with equity is that it is not as liquid as tier-one capital: if a bank tries to sell a bunch of its equity to raise cash, the value of the equity will fall.