How Equality Hangs in the Balance Sheet

By Karen Shaw Petrou

As Thomas Piketty’s book and much other research show, economic equality is a cumulative-return construct – that is, absent engines of growth, the rich get richer and middle-income households fall ever farther behind.  Thus, when bank balance-sheet capacity shrinks and lending to core economic engines such as housing and small business falters, income distribution widens and wealth inequality grows inexorably worse. 

It does not matter if lost balance-sheet capacity is due to loan losses or higher capital requirements, regardless of the deserved pain of the first for profligate banks or the policy benefits of the latter.  What matters to equality is whether banks can serve as equality engines by transforming savings into productive loans that lead to investment and macroeconomic growth.  When they can’t and non-banks do not step in, equality suffers, and grievously so as new studies show.

A new Fed staff paper sheds important light on how post-crisis rules interact with monetary policy to make post-crisis recovery so much harder, slower, and unequal.  In short, and as demonstrated in other authoritative research, the less bank balance-sheet capacity available, the less small-business lending and the deeper the loss to employment.

From the Bank Balance Sheet to the Unemployment Line

The new Fed staff study does not directly look at balance-sheet capacity per se, instead focusing on what happens when multi-market banks lose their ability to lend due to housing-related losses.  These losses adversely affect bank capitalization and thus the extent to which weaker banks can support local recovery.  Multi-market banks are assessed in order to determine the extent to which lost small-business lending is due to reduce local demand or to bank balance-sheet pressure. 

This is a critical question.  Just a week or two ago, FRB Chair Yellen pushed back again on assertions that small-business lending is down due to post-crisis rules, saying that any drop in lending – and she isn’t sure there is one – is due to reduced demand, not supply shortages.  If local demand is down, then it is likely that both in- and multi-market banks would show reduced lending; if only multi-market banks show reduced lending, then the study postulates that this is due to balance-sheet capacity, not weak local demand. 

Indeed, the multi-market effect, if different than that observed for in-market banks, may well be compounded by or even just due to the fact that multi-market banks are bigger and thus subject to particularly costly post-crisis rules.  These standards of course than heighten the increase of credit losses with higher capital standards that make resumed lending still more challenging. 

There is no reason why housing losses are different than any others or, for that matter, from other pressures that reduce bank balance-sheet capacity for new lending.  As the study notes, a 10% decline in house prices is associated with a 0.8% quarterly decline in equity or a 9.7% decline in equity from 2007-10.  Real estate shocks were of course critical during the great financial crisis, but there is no reason to believe that a crisis caused by, say commercial loans, would have different implications for bank equity nor that reductions in balance sheet capacity equivalent to those generated by credit losses resulting instead from heightened regulatory capital requirements would have had a less severe impact on small business lending and, thus, on employment.  Put another way, equity can go down due to losses or it can go down in relation to what banks must have due to new rules.  Combine losses and rules, the lost balance-sheet capacity is certain and severe.

Key findings in this study are that:

  • When banks are exposed to a 10% decline in house prices across their market, there is a 16% decline in small-business lending and an 11% decline in mortgage originations in affected markets in concert with a four percentage point decline in mortgage acceptances. Further, a one standard deviation greater bank exposure to house-price declines reduced local employment by 3% between 2007 and 2010.
  • The multi-market analytical approach shows that employment losses are due to balance-sheet capacity, not local house-price declines.
  • Deteriorating bank balance sheets lead to reduced labor demand because “young firms” – i.e., start-up small businesses – depend on bank credit, leading to a loss of as much as one million jobs. A review of overall credit availability is found to mask the impact of reduced small-business lending due to the importance of small businesses to new employment. 

One could sum all this up by saying that less bank balance-sheet capacity leads to less lending, especially following credit shocks in concert with higher regulatory-capital requirements.  This may seem intuitively obvious, but the role of lending in generating economic growth and the impact of new rules has been hotly disputed.  U.S. regulators started to rewrite the banking rules, and economic growth failed to respond to unprecedented accommodative monetary policy.  Ms. Yellen may have reconciled herself to this by now, also telling Congress recently that, even if banks weren’t making loans to small businesses, non-banks were replacing banks and, for good measure, doing banks one better with better loan products.  Over time, she may well be right and non-banks will become engines of equality as banks sputter out.  However, as I said, economic equality is a cumulative affair.  It will be hard, if not impossible, to make up all the lost equality ground since the great financial crisis without equalizing fiscal policy.  It’s only going to get harder no matter what non-banks do unless U.S. regulators reckon with the results – unintended though they are – of post-crisis financial policy, allow financial markets to normalize, and permit sustainable credit to flow again from regulated institutions.

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