Bank capital constraints and credit rationing

: a new interpretation based on Keynes’ theory of liquidity preference

Abstract

This thesis presents a Post Keynesian (PK) endogenous money framework for understanding why capital constraints can cause the banking system to restrict the supply of credit to creditworthy borrowers and why these constraints cannot always be avoided by raising capital externally in equity markets. It employs Keynes’ theory of liquidity preference (LP) to make three distinct arguments: First, banks’ liability-structure is underpinned by a ‘liquidity hierarchy’ in which banks’ ability to have their deposits accepted as substitutes for money depends on the amount of equity-capital that they have available. Second, when banks lose confidence in their abilities to calculate risk, they try to increase their own capital-ratios in order to absorb potential unexpected-losses. Third, the inability of the banking system to raise sufficient capital externally during economic downturns can cause it to restrict the supply of credit to the economy. This occurs because an increase in the LP of equity investors leads them to restrict the supply of capital funds to banks. Since capital availability imposes a quantitative limit on the overall risk-taking capacity of banks, such capital-constraints prevent banks from satisfying all the demand for credit, even that from borrowers that they deem creditworthy. One of the main contributions of this thesis is its use of Keynes’ theory of LP to explain the behaviour of investors in bank-equity in a way that is different from both the classic portfolio-choice interpretation of Tobin (1958) and standard PK interpretations (G&L, 2007). A theoretical Stock-Flow Consistent (SFC) model is used to contrast the contending interpretations of LP through different specifications and closures and to illustrate the different macroeconomic implications with analytical solutions and simulations.

Date of Award	1 May 2021
Original language	English
Awarding Institution	King's College London
Supervisor	Engelbert Stockhammer (Supervisor)