I certainly agree that a more radical reform to the banking system is required. The obvious vulnerabilities of the banking system were uncovered following the great crisis of 2008. The many weaknesses that were exposed included weak capital and liquidity requirements as well as financial weaknesses like poor leverage management and poor risk management. According to the G20 meeting that happened in Washington in 2008, these issues were said to have just made the crisis a whole lot worse. BASEL III is an example of the number of changes and new schemes that have been introduced to the banking system post the 2008 crisis. However, there has been arguments which do contend that these changes are not sufficient as they fail to address the instability of the banking system. In this essay I hope to present the argument that a more radical reform of the banking system is required. To achieve this, it is essential to critically analyse the BASEL norms especially BASEL III as well as the current issues in the banking system.
The BASEL Norms:
As a means of dealing with the capital requirements of the banks the Bank for International Settlements created the BASEL norms. In 1988 BASEL I was introduced as a framework for calculating a bank’s capital to risk weighed asset ratio. It breaks down bank’s capital into two types: firstly, there is core capital which comprises of equity capital and disclosed reserves also known as tier I and secondly there is supplementary capital which comprises of items such as undisclosed reserves and revaluation reserves, also known as tier II.
When BASEL II was introduced in 2004 it often gets the brunt of the blame for the crisis due to its laxness. The system itself was seen as a more comprehensive version of banking supervision in comparison to BASEL I. As well as standing on three pillars it only included the capital to risk weighed asset ratio calculation. BASEL II required 4% tier one capital and 4% tier two. Refereeing back to the three pillars of BASEL II; Pillar 1 was all about the minimum regulatory capital and also provided an outline for capital sufficiency standards. Pillar 2 provided the key principles for risk management guidance, supervisory review and supervisory transparency and accountability. Lastly Pillar 3 stimulated market discipline through the development of a set of disclosure requirements that allowed members to access key pieces of information on risk exposure. When the 2008 crisis hit however, BASEL II was exposed as having multiple weaknesses which in the end were said to have proven to be useless.
BASEL III was created in 2010 with hopes of being fully implemented by 2018. It was created as a remedial measure to deal with the fallout of the 2008 crisis. BASEL III has three fundamental elements which include higher quality of capital, higher capital ratios and tighter liquidity requirements. BASEL III also uses the three-pillared approach introduced by its predecessor BASEL II and increases the capital requirements . Although the 8% core capital requirement remains, with the additional buffers that have been introduced it increases the amount to roughly 15%. The increase on capital requirements were made with the intention to be increased when the economy is strong so that it can be called upon on in periods of pressure. BASEL III, despite being an attempt at reform, has come under significant fire from critics. These critics claim that there is the potential for further economic damage. BASEL III brings with it a major structural change to the industry, reversing developments that have been in train for nearly forty years. In this case the required changes include revised internal processes for assessing and taking business decisions, such as approval of customer loans; more effective communication of bank business models and business opportunities to the investment community in order to persuade investors to produce necessary long term funds; and possibly also a shift of relatively risky (but still potentially value creating) loans from bank balance sheets to long term institutional investors better placed to absorb these risks. For that reason, the structural shift is definitely the biggest danger presented by BASEL III. We must agree with the critics in the sense that with Basel III there is a real danger that reform will limit the availability of credit and reduce economic activity; but this danger is widely misunderstood. The problem is not higher capital and liquidity requirements per se (these have little impact on the fundamental cost of banking activities) but rather the challenges of structural adjustment, and the widespread consequent changes necessary across the financial services industry, which threaten to starve the economy of credit while the adjustment is still incomplete. When looking at the big picture, there seems to be a strong possibility that BASEL III could turn out to prove itself as tremendously problematic. Essentially “if this is allowed to happen then the cure will turn out to have been worse that the disease”.
Within the Eurozone the countries involved do not share a banking system just legal tender as it is seen as a currency union and not a monetary one. As a result of this it does not have the components of a typical monetary union so when the crisis hit, the Eurozone was basically powerless to deal with it. Martin Wolf contends that the Eurozone is likened to a bad monetary marriage. “After 2008, cross border private financial flows suffered a series of sudden stops. Countries embedded inside a currency union were more vulnerable to balance of payments financial crises than those with floating exchange rates and their own central banks.” If we look at this from Wolf’s viewpoint, banking, fiscal and political reforms are necessary in order to prevent a recurrence of the crisis
Radical Reform
In terms of a more radical reform of the banking system being needed, If I was to put forward a reform proposal I would propose the use of full-reserve banking. Full-reserve banking when banks are required to keep the full amount of each depositor’s funds in cash, ready for immediate withdrawal on demand. Under full-reserve banking, money creation is centralised with an independent public institute and banks cannot modify this government guaranteed stock. The payments system is separated from credit creation. Current accounts in banks have to be fully backed by reserves of the public institution. They cannot be used as funding for loans and therefore the accounts earn no return are always accessible. Under this system, banks no longer have the power to create money, they simply move it around from place to place. Money in transaction accounts would be run-proof, and while money in investment accounts is at risk, this risk is borne by the depositor. Given that the full reserve banking is merely a proposal, its proposition is obviously going to be met with questioning of whether it will be effective. Following the analysis and presentation of a stock-flow consistent model, it has been cited that in a steady state, full-reserve banking can accommodate a zero-growth economy and provide both full employment and low inflation. Given that the banks would no longer be able to create money, full-reserve banking would obviously be less inflationary than the current system in place. However one downside would be that there would be less credit in the system which could damage some kinds of entrepreneurialism or investments. Nevertheless this negative could be worth it looking at Hyman Minsky’s opinion that banks essentially use credit to fuel unsteady asset price bubbles. Although full-reserve banking would not provide inherent stability, banks would be better equipped to assess how much capital they would need in their investment pool to meet demands from depositors. Nevertheless, even though there are many advantages to full-reserve banking it is very unlikely that we would ever see it in action. If it was implemented it would cause a immense financial shift in the Eurozone. It would also prove very unpopular with the larger banks as it would inevitably cut into their profitability.
Hyman Minsky said that the banking system is inherently unstable. His key point was that “stability is destabilising” which essentially means that when the dust settles following a crisis and stability is finally restored that people then grow to forget the previous crisis and the apparent stability within the system actually leads to more reckless lending policies. Essentially he is saying that if the new policies warrant some success after a few years, eventually they will cause the same problems that they were initially created and introduced to prevent in the first place.
Conclusion
To conclude, the crisis of 2008 certainly caused considerable damage to the banking structure. However, be it an oxymoron, the weaknesses it then revealed within the system can be seen as a positive occurrence. There is no doubt that the banking system is in need of redical reform, but this would not have been acted upon if the crisis had not happened. Having said that it is evident that the new schemes that are being implemented by the Eurozone do not seem to address the instability of the banking system. To revert back to Minsky’s hypothesis of the inherent instability that is within the banking system, it seems that there is a chance that when the crisis is inevitably forgotten about in years to come, complacency will probably cause the cycle to repeat itself once more. In my opinion the only guaranteed way of preventing this potentially disastrous problem from happening again is a more radical reformation of the banking system.