There has been a lot of debate on this blog recently about the way in which I use the word capital.
I have used it to describe the deposits made by people with banks because when a saver hands over the their money to a bank it becomes the bank's property and the saver has little more chance of recovering from that bank in the event of the bank becoming insolvent than a shareholder has of securing a return on their investment in that same situation. This, of course, is why the government guarantees bank deposits to the sum of £85,000.
In that case, it is my suggestion that a bank treats the deposits made with it to by savers as a part of their capital because they provide it with a buffer against the risk of insolvency if they were to go bust.
I do that because the reality is that this is exactly how it would seem they would behave in that situation, and as a consequence, I think the description is correct.
Doing so I am doing nothing more than recognising the moral hazard created by this situation, where bank directors, protected by limited liability and the failure of regulators, can be indifferent to the risk faced by all providers of finance to their bank - which is exactly what bank depositors, who are unsecured creditors of the bank are. Adam Smith pointed this out in 1776. Not much has changed since then.
Despite that, many people have objected to my use of the word capital in this way. In particular, they say that capital has a very definite connotation within banking, which implies that it refers to the equity share capital of the bank.
However, equity capital is itself a nebulous concept. That form of capital can be made up of the money paid by shareholders on the initial subscription for shares. It can also include the share premium account paid by subsequent shareholders who apply for their shares after initial subscriptions are paid. And it can refer to the accumulated profits not paid out to shareholders. In addition, it can also refer to other reserves, such as revaluation reserves that arise as a result of the bank deciding for its own good reasons that its assets have a worth over and above the sum that they originally paid for them, giving rise to their revaluation and these supposed reserves as a consequence.
Altogether, these figures can be described as shareholders' funds. But whether they are equity capital as such is less clear, precisely because some of them can be readily repaid to shareholders at the whim of the directors, and others have to be retained within the business for a very specific reason. That is why this form of capital is very particular and subject to regulatory definition, but to pretend that regulation used for this purpose defines what capital might be is absurd.
That is because that regulatory definition does not recognise the economic reality of the situation to which I was referring, and will continue to refer, which is that whatever regulation says, a bank can treat its depositors as the providers of unsecured funding to it that can be put at risk by their trading activities and be lost by those depositors in the event of insolvency. The fact that this has not happened for 160 years is neither here nor there. The truth is, it could happen, and therefore, my suggestion that those funds rank in a broadly similar fashion to and are akin to the supposed equity capital of the bank is fair, most especially when parts of the shareholders' funds of a bank are also capable of being withdrawn at short notice.
Those objecting say that I do not understand capital because it has this very precise regulatory definition. But the reality is that those making that claim clearly do not understand the concept of capital. In both accounting and economics as well as in reality, capital has many forms.
There is obviously equity capital of the form that I have already noted.
But there is also human capital, which represents the combined resources of those people who work for an organisation or who live in a country and who can apply their skills for the benefit of the company or society of which they are a part.
Then there is natural capital, which combines the environmental and other natural resources of a society, whether in a particular region or worldwide.
Environmental capital is a subset of natural capital.
Intellectual capital is also different from human capital because intellectual capital refers to knowledge, but human capital combines intellectual capital with wisdom, which is in itself another form of capital.
I recently heard a description of the difference between intellectual capital and wisdom. Intellectual capital embraces the knowledge that a tomato is a fruit. Wisdom makes it clear that tomatoes do not belong in fruit salad. The example is flippant, but the point is clear. These two forms of capital are not the same.
What is also clear, as a consequence, is that capital comes in a multitude of forms. And yet, those who wish to use the term merely to describe the funds supplied by shareholders to a company ignore this point, and they are wrong to do so. Organisations of all sorts apply the concept of capital in many ways. They will seek to increase the human capital of their organisations, and the intellectual capital, and the wisdom of the organisation as a whole. Many also now accept their responsibility to manage its environmental capital. In time, many more will accept the need to manage natural capital.
Along the way, directors have a responsibility when managing a company to ensure that it is solvent. That requires them to manage its working capital, which are the funds available to settle liabilities as they fall due.
What all this makes clear is that capital does not just exist in the form that is being claimed by those who criticise my interpretation of the word within the context of banking. Capital is a flexible concept that represents the value of the resources available to an organisation for it to use in pursuit of its goals. I suggest that those who deposit funds with a bank make resources available to it, which is indisputable. That is it. There is nothing more or less to it.
And even then, the term can also be used on the flip side. The flip side means that whilst all the concepts of capital to which I have just referred are on the credit side of the balance sheet, representing the net worth of the combined capital that an organisation has under its command on which others have a claim, there is of course a debit side to this equation, which is the actual value of this capital in use.
This debit side does not represent claims by others on the entity for the capital provided (that's the credit side) but does instead represent the actual assets in use in the organisation that make an organisation of any sort, whether it be a country, a local government, a charity, an NGO, or a company, actually function. These assets might be:
- Tangible assets, like equipment and property
- Intangible assets like copyrights
- The knowledge of the people employed
- The natural assets entrusted to the organisation
- Short-term assets like stock (inventory), work-in-progress, debtors (receivables) and cash
- Investments
They all fall in some way into the asset categories already described or are, in the case of the penultimate bullet point, working capital.
Capital is a vital concept. It is at the very core of accounting, which is the context in which I use it. In fact, what accounting measures is the change in the capital of an organisation over a period of time. It does not necessarily measure profit. That is just one particular form of accounting which measures the change in the retained shareholder funds of an organisation over a period. A broader concept of capital involves changes in equity capital, changes in human capital, changes in natural capital, and other concepts as well. In other words, an understanding of capital requires anyone who has a responsibility to realise that a narrow definition of capital is absolutely the worst form of understanding that they can have if they are to be prepared for the task that faces them.
In that case I use a broad definition of capital for good reason. I believe in holistic management, whether at a micro or macro level. If that's the right way to approach management, and I believe it is, then it is wrong to use narrow definitions of capital because what we need is this broad understanding that in our society there are many capitals that we must protect, nourish, invest in, develop, and preserve, and of all of these the one that might be least important is the concept to which those criticising me make reference, which is shareholder equity capital. That is because that cannot preserve our future or deliver our well-being. But the other forms of capital to which I refer most definitely can.
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The standard economic definition of capital is “the input into the production function that isn’t labour”. This isn’t a good definition because it makes a lot of sense to disaggregate production into a wider range of inputs e.g. plant and machinery (including devices such as computers), land, natural resources, energy (as pointed out recently by Steve Keen), technological expertise, etc). There is also human capital, which is the skills and knowledge of labour, and perhaps entrepreneurship as a separate production factor too. There is also the separate concept of financial capital which doesn’t enter the production process directly but is one way of providing funds for investment. The economic critique of the concept of capital made by the Cambridge economist Joan Robinson in 1953 and then developed over the next 20 years was that (a) production capital and financial capital were two very different things, often conflated by economists, and (b) there was no coherent way of valuing production capital in order to use it as a “capital stock” in aggregate production function analysis. This point was never satisfactorily answered by mainstream economics.
Thanks Howard
HI Richard,
I may have missed this completely, but I assume you are talking about precision and context. Precision is important, there is not enough in todays world, however context is also important, in order to understand what people communicate.
Eg. if I say ” take a bow” you may imagine I’m suggesting a bend at the waist, but if I follow it up with ” and run it across the strings”, you now understand my first phrase.
“Bow” is imprecise, but context gives it precision.
I assume that your use of the word “capital” is identified by the context you give it.
Or maybe I have got the wrong end of the stick (brown, comes from trees)
Regards
I am not requiring context because I use the broad term – those seeking to restrict my use of the word are
Everything you have said above seems redolent with the concept of ‘resources’ and the excellent holistic resource accounting model you developed a while back which made a lot of sense.
In housing development, we use money (reserves and surpluses) and the housing revenue account (HRA) borrowing powers we have as a resource or as an asset to create other more tangible assets – the affordable council houses we need to build for the waiting list.
These assets also become liabilities of course, since we need to maintain them in the short and longer terms which is where the rent comes in (which also pays down the loan) so that the value of the assets is maintained. A virtuous circle that has been made much harder by central government over the years. There will be a time – since HRAs are now supposed to be self funding and managed by local authorities – when we will have essentially used up most of the headroom in the HRA and development will slow down or just stop – around 2050 if not sooner the way construction prices are going.
In short, we will need more resources – capital in this case – and no one knows where that will come from at the moment.
Thanks
You get it
I thought you previously said that banks don’t use customer’s deposits in a bank?
So how can the shareholders be using it as ‘capital’ in your definition?
And how can there ever be a run on a bank if the deposits aren’t after used elsewhere and are therefore always there to pay out savers.
And in the event of an insolvency, shareholders equity and then the government guarantee apply before any deposits are at risk.
Historically, how much has it cost for the government to provide this guarantee historically?
I did not say the sharehodlers did. Shareholders do. not run companies. I said the bank does – and referred to the directors.
I have explained runs on banks many times. Thety result from other banks withdrawing credit.
The costs of the FSCS have been discussed here in comments recently.
Depositors are unsecured creditors of a bank. This is a simple fact that scarcely needs elaboration and is true whatever word you use to describe it – deposit, loan, capital or anything else. Certainly, this means they are at risk if the bank fails and shareholders/directors are protected by limited liability.
Every profession has its own jargon and sometimes it is there to confuse outsiders but, more often, it is used as a shorthand to describe something specific/important to that particular type of business.
Banking is different to every other industry. First, it is central to everyone’s life; it’s virtually impossible to operate without a bank account these days. Second, in most business capital/money is used to create a product; in banking, capital/money IS the product so care is needed when using these terms. Third, banks are highly leveraged – far more so than any other type of business which creates unique issues for banking.
Consequently, it is highly regulated.
You say… “a bank treats the deposits made with it to by savers as a part of their capital because they provide it with a buffer against the risk of insolvency if they were to go bust” and I am not sure what this means.
Equity Capital IS a buffer against failure; when a bank loses money because a loan defaults or a trade turns sour the shareholders see the value of their equity decline and it is this buffer that protects lenders/depositors meaning they can be repaid in a timely basis in full. Equity capital is the buffer, Debt (deposits) IS the wall.
Regulation since 2008 has all been about beefing up this buffer and it is roughly 3 x what it was compared with 20 years ago. In banking “Capital” typically means “Regulatory Capital” ie. anything that counts towards this buffer (according to the regulators); “Reg Cap” is only capital that can genuinely be used to absorb losses and protect lenders/depositors.
If this buffer goes below a certain level dividends and bonuses must be suspended. If it goes lower again Regulators will come in and run your bank. If it then falls below another level the bank must cease trading and will be unwound. Capital cannot be paid out at the “whim of the directors” (as you imply).
Also, banks are highly restricted in “what they can do with depositors money”. The simple model says
a) Bank A makes loan to X and creates deposit (in X’s name)
b) X buys car and instructs Bank A to pay Bank B (the car dealer’s bank)
c) Bank A borrows from Bank B in the interbank market to keep its Reserve Balance unchanged.
… but this is not what happens because regulators do not permit lending (of this type) to be financed in the interbank market; LCR and NSFR rules don’t permit it. Borrowed money (Debt Capital) cannot be used freely if you are a bank.
So, I full accept your broad definition of Capital and in many situations the holistic view is essential… but the difference between equity and debt capital is so different in banking it would be better to always make the distinction – particularly when we are discussing quite detailed banking activity (eg. Remuneration of Reserves etc..)
But then we are discussing regulation, not capital…
That’s my point
Banking and money have been regulated by government for at least 4,000 years. Any discussion on banking is always about regulation.
I am quite happy with the way that you use the word “Capital” in its broad sense in most contexts…. but my plea is that when discussing banking you use more precision. To do otherwise promotes confusion and trolling.
Sorry Clive, but I won’t be changing unless I am specifically discussing regulation
I won’t play on a plying field defined by those seeking to maintain the status quo. That never works.
I am not trying to be awkward – I think you and I both want banking reform along (roughly) similar lines. I also think we are both looking for real, practical solutions that have a chance of implementation… and these solutions are ALWAYS regulatory.
We start from where we are and this requires us to understand the current regulations that drive bank behaviour… then we can see what regulatory changes are required to deliver the outcomes we want. It is always about regulation.
I will shut up, now. Your blog, you can use words however you like.
My concern is aways with substance – regulation has to refelct that, not vice versa
“Regulation since 2008 has all been about beefing up this buffer and it is roughly 3 x what it was compared with 20 years ago. In banking ‘Capital’ typically means ‘Regulatory Capital’ ie. anything that counts towards this buffer (according to the regulators)”.
I confess I take Clive’s point here, because that is what bankers believe; and they do not think outside the box, so this will not be resolved – it will just go on and on. I think it also allows trolls to troll, and do what they do best – cause confusion.
At the same time, banking is a matter of double-entry; and accountants and not bankers have long established the precise meaning of the technical terms that govern double-entry. Bankers should not ever have been in the position to make up technical terms in banking using what are already long established and fundamental accounting terms (in another discipline, but one fundamental to banking since Luca Pacioli, “Summa de Arithmetica, Geometria, Proportioni et Proportionalita”, 1494); with very precise meanings. But we are where we are; which is very typically British – up to our chins in confusion and mess.
Noted
Thank you, Richard and Clive.
I know what Richard is getting at, but must echo / stress Clive’s caution.