Disclaimer: this particular post is going to be fairly technical. And I’m doing it because I have readers in the finance/banking field who may or may not know what Basel III actually entails. But I have a post planned for tomorrow that might change the way you look at the poor (I’m very excited about it). So please don’t run away indefinitely. Maybe, just for the day.

So I recently wrote a post on banks, fractional banking, and the seemingly unsolvable problem of bank crises. And I genuinely think it’s worth reading – because banks are fascinating, and we rely far more on the psychological stamina of the population as a whole than we realise. And to briefly recap:

The Underlying Fundamental of a Banking Crisis

Banking crises start for a number of reasons (contagion*, unstable monetary policies, etc). But those reasons simply trigger the underlying fundamental problem: which is that your money in the bank is mostly hypothetical. The banking system relies on the statistical improbability of most of their depositors demanding most of their money at the same time.

And, I mean, it’s not an entirely unreasonable assumption to make. We’re all relatively independent individuals, with differing financial resources and needs. And in a relatively closed system – we must put the money somewhere. The trouble is that we’re not independent all the time – just, when times are good. Much like a herd of zebra, we wander about swatting flies and frolicking in the long grass, pretending like we’re doing what we want to do. And then there’s whiff of lion, and suddenly, everyone moves together in one swirling herd of dust and stripes.

We’re herd animals. And when the herd is spooked, it stampedes.

In all fairness, the banks and the governments that regulate them are not entirely unaware of this. Which is why the banks have reserve requirements. And it’s why those reserve requirements get higher and more stringent after every banking crisis. In theory, we’re slowly iterating toward a place where the reserve requirements are high enough to cater for the impact of any crisis.

But not without the banks kicking and screaming. Or the rest of us, for that matter.

Why No One actually wants higher Reserve Requirements

As soon as the bank bailouts started happening, the news was full of griping protestors declaring the general evilness of banks and calling for better regulation and higher reserve requirements. And strangely, today, the complaint is that the banks aren’t lending any money. How are those two complaints happening concurrently?

What we all must realise: hiking a reserve requirement is just as much an austerity measure as a spending cut. It’s just monetary austerity instead of fiscal austerity.

Let me explain: let’s say that there is $1 trillion of money moving around in the economy, and the reserve requirement is 10%. How did we get there? Well, somehow, the Reserve Bank created $100 billion and injected it into the economy (usually, this happens when the Reserve Bank buys $100 billion of government bonds**). Then, via fractional banking (see last week’s post), the banks turned this $100 billion into $1 trillion by lending out 90% of all money deposited with them. The banks are left holding $1 trillion in deposits, $900 billion in loans made, and $100 billion actual cash (the 10% reserve).

Then some kind of a crisis happens, and the banks need to be bailed out. Some angry politicians and ignorant civil protestors call for higher reserve ratio requirements. Because clearly, the banks should have had enough money to protect themselves, and they should have seen this coming.

Let’s say that the protestors get their way, and the banks are forced to have a 20% reserve requirement.

Well now, the banks need to have $200 billion in actual cash to cover their deposits. And where are they going to get it from? Well they’re certainly not going to lend any more money – because they don’t even have enough cash on hand to cover that $200 million! And there’s actually not enough cash in the economy to meet that reserve requirement. So what they’re going to do is collect some of the loans that they’ve made, and they send out the debt collectors.

And the debt collectors cut the loan balance down by $500 billion. And that money can only come from other people in the economy (it gets messy) – so banking deposits also go down by the same amount. And it’s only when the banks have $500 billion in deposts, $400 billion in loans and $100 billion in cash that it meets reserve requirements. Doubling the banking reserve requirements HALVES the amount of money in the economy.

THAT, folks, is real austerity.

Enter: Basel III

The banker compromise is to say: the problem is partly the quantity of the reserves – but it’s also the quality of the reserves that we’re holding onto. Because bankers aren’t crazy about keeping those reserves as actual cash. So they’ll put them into “investments” that someone (Basel II) agreed to as being “safe enough to count as a reserve”.

And that is an actual issue – because sovereign bonds of a certain credit rating were considered “safe enough to count as a reserve”. Case in point: Cyprus, who was like, “but Greece has a AAA rating!”

Bazinga.

So the Basel III requirements are being introduced to improve the quality of the reserves, and the way that the reserve requirement is calculated.

The Basel III Capital Reserve Requirements

Note: Basel III also makes some corporate governance amendments, but the dramatic impact will be the changing guidelines for the composition of reserves.

Basels I and II ranked reserve requirement components into three tiers:

1. Tier 1 capital consists of bank shares (the ordinary shares of the bank issued to shareholders) and retained earnings (past profits made by the bank). It’s also known as core capital. It may also have included some fun hybrid instruments that the bank had managed to convince the regulator/auditor/both of counting as Tier 1 capital.
2. Tier 2 capital consisted of revaluation reserves, some types of provisions, preference shares, and other debt-equity hybrid instruments.
3. Tier 3 capital included other provisions, general loss reserves, and other types of debt.

So let me take a moment to explain – because none of the above really sounds like “sovereign bonds”. A diagram:

Reserve requirements are all about relationships. So the liquidity requirement (being the requirement that some money be kept in cash and close-to-cash investments) is determined by the ratio of Loans Made (Assets) to Liabilities (Deposits Made and other liabilities). Another approach, because “equity” is the difference between Assets (most of which are Loans Made) and Liabilities, is to look at Equity and use that as the measure.

In terms of Basel I and Basel II, the banks were able to count some of their liabilities (like loss provisions) as part of their equity for reserve requirement calculations. This decreased their liquidity requirement, so they ended up needing smaller cash reserves (and could therefore make more loans).

Basel III is all “hell no” to that. Tier 3 capital will no longer count. Tier 1 capital can consist only of share capital and retained earnings (farewell ye olde hybrids). And Tier 2 capital is being, euphemistically, “harmonised”. And, also, the reserve requirements are increasing.

At the same time, the assets that will qualify as “part of the liquidity reserves” are being limited and subject to varying caps.

So it all sounds really prudent and corporate governance-y.

But.

The Delay in Implementation

The new measures keep getting pushed back by governments. They were meant to roll out in 2014. But then that turned in 2015. And then you hear rumours of 2019.

Critics are quick to blame the Big Bank lobbyists for being evil and preventing the implementation of something that is fundamentally necessary.

We must be clear. The real losers, when the banks stop lending money, is not the banks. Sure – they lose some interest. But the macro-impact is on everyone.

Don’t forget! Double the reserve requirement, halve the money supply. Under Basel II, you were looking at an 8% capital ratio. Under Basel III, it’s a 13% minimum.

That’s, ah, quite an increase – relatively speaking.

*There is an old post on contagion floating about from the time when Greece was still a real concern. It’s called: “Contagion. And why Greece is Contagious.” I’ll be honest – the post is flawed (in particular, it ignores the relationship between public and private sector debt). But it does explain how contagion works.

**It’s the very definition of “quantitative easing”. Only this was the original.