The funds diverted to those counterparties reduce the amount available to others, intensifying the scramble to get to the front of the line. For non-financial firms, an automatic stay mitigates a disorderly destruction of value. But banks are in the business of circulating funds and cannot function under a persistent payment freeze. There are also wider economic costs. Smaller firms without easy access to public debt markets face switching costs if they have to establish new banking relationships. While they are searching for new credit, they are likely to cut spending, adversely affecting the economy.6 Failure therefore brings substantial costs, for both the failed bank’s creditors and wider society. The equity owners need not internalize all these costs so debt finance should carry a risk premium, incentivising equity to be preferred over debt, ie lower leverage.7 Taken together, these various departures from Modigliani-Miller’s simple world mean that a bank’s overall funding costs do depend on its capital structure, but in a non-linear way. So long as a bank’s capital buffer is sufficient to make the perceived probability of bankruptcy remote, the bank will most likely want to economise on equity, if only for tax reasons. By contrast, if capital levels are too thin, bankruptcy will be a real possibility. Economising on equity capital is then likely to prove counter-productive as debt-holders, with an eye to the costs of resolution or liquidation, will demand ever higher rates of interest.
In this hypothetical scenario, the policymaker has something of a tightrope to walk. For an individual bank, cutting risk exposures by reducing lending might at first blush seem to be a step towards restoring capital adequacy. For the system as a whole, however, it would clearly be counterproductive for all banks to delever in that way. The better path, not only for economy but for individual banks as part of the financial system, would be for banks to strengthen their capital structure so that credit supply was not impaired. A second distinction is between the market and the macroprudential policymaker having the same information and views on what ought to be done (Column 1, Figure 1) and their having different information and views. Most interesting are those cases where the market and the FPC are out of synch. Suppose the market spotted first that the system was dangerously under capitalised. Banks’ debt funding costs would rise sharply and would remain elevated until the market saw evidence that either the banks or the authorities were grasping the nettle. A belated but decisive action to raise capital levels would then come as welcome news (Column 2, Row B). Funding costs should fall back, perhaps significantly, and credit conditions could well ease. That would take some of the edge off the downturn. I want to stress that in this particular hypothetical scenario, an increase in capital requirements has the effect of easing credit conditions.