Sprizouse asks, in the comments:
If the banks all got capital injections at 5% why do we expect LIBOR to fall? The banks have to make 5.01% on the money, just to make a profit. Why isn’t this troubling for anyone else?
It’s the difference between funding and capital. Banks need both, but it’s important to distinguish their cost of funds from their cost of capital.
A bank’s cost of funds is the interest rate at which it can borrow money. Banks borrow money in many different ways: the historical one is by taking deposits, which generally pay low or nonexistent rates of interest. Banks can also borrow directly from the Fed, or from each other. Add it all up, and you get the a bank’s cost of funds. If a bank then lends out those funds at a higher interest rate than it’s paying to borrow them, it makes a profit.
But banks also need capital. If I take your $1,000 deposit at 1% and lend it to Joe the plumber at 7% so that he can buy his business, that’s great, I’m making lots of money on the spread. But Joe’s only going to pay me back slowly over the course of many years, while you can demand your $1,000 at any time. So I need some capital lying around for the depositors to have access to.
More to the point, I can’t be sure that Joe the plumber is going to pay me back. If he gets mobbed by angry partisans and his business fails, then I lose the $1,000 I lent him, while still owing you, my depositor, $1,000. So I need to have a capital base — extra money — which I can use to repay the people who lent me money, even if the people who borrowed from me default.
Let’s say that regulators require a capital ratio of 10% — which means that for every $1,000 in loans, the bank needs to have $100 in capital. Then a bank boosting its capital base by $25 billion could in theory make an extra $250 billion in loans. Yes, it will be paying 5% interest on that $25 billion — that’s $1.25 billion per year. But if it lends out $250 billion at a spread of say 3 percentage points over its cost of funds, then its profits from the loans will be $7.5 billion per year — more than enough to cover the interest payments on its capital base, plus a certain amount of delinquency. If a bank’s cost of funds is 1.5% and it’s lending at 4.5%, then that’s a very profitable operation, no matter what its cost of capital might be.
That’s the theory, anyway. If the banks don’t beef up their lending operations, then yes it will be harder for them to make the interest payments on Treasury’s new preferred stock. But they don’t need to lend at more than 5% in order to make money: they just need to lend at more than their cost of funds, whatever that might be.
Update: There’s much more to this, of course. A real live banker emails to explain the crucial difference between reserve ratios and capital ratios:
It’s important to distinguish between
– the reserve ratio, i.e. how much cash banks have to hold (at the central
bank) for the deposits they take in. This is a ratio that only considers the
left-hand side of the balance sheet
– the capital ratio, i.e. how much tier 1 (or tier 2, or whatever) they have
to hold on the right-hand side of the balance sheet against their risk
weighted assets on the left-hand side.
An increase in capital means two things: it increases cash and it increases
capital. Now, to determine how much additional lending a bank can do, we
have to look at both ratios: reserve and capital.
The example in your blog entry should refer to the reserve ratio, and not
the capital ratio. Because regarding the reserve ratio, your numerical
example is correct: $25bn more in cash can generate up to $250bn lending (if
the reserve ratio is 10%)
But from a capital perspective, banks could potentially lend a lot more with
the increase in capital. Exactly how much more depends on the risk-weighting
of these loans. Regular mortgages, for example, have a risk-weighting of
about 20% (meaning that only 20% of the par loan value enters risk-weighted
assets). Banks then need to hold about 8% against risk-weighted assets. You
see that this means that $25bn can support loans in well in excess of
ߣ250bn.
My point is that it’s important to make a clear difference between the
reserve and the capital ratio.