When I was just a young accounting kid, growing up in a small-town office family*, I used to have regular email communications with the worldly cousins in the Big City**. We would visit once or twice a year (they never visited us) and stay in out-of-town lodges located near the South African equivalent of strip malls. So obviously, everyone would always be happy to get back to our Mountain and the (much better) coffee shops where the baristas know you by name***.
And while we were busy doing the audits of wine farms and asset managers and big insurance, they were working with the banks. And the buzzwords would float around: “basel requirements” and “capitalisation ratios” and “risk-weightings”. Terms which have, literally, been all the rage since 2007. Notably, the bankers have been talking about “Basel III” in hushed tones – trying (I assume) not to attract the attention of anyone named “Dodd” or “Frank” in America****.
Anything that attracts this level of attention is something worth writing about. Especially when Senators Vitter and Brown are proposing to abandon Basel III altogether and insist on just plain equity capital.
<collective gasp from the American banking readership>
Here’s the article: “Ditch Basel Bank Rules“.
How Traditional Banks Began
Before we get to the fun part about capitalisation, I’d like to do a quick roll through history to explain how we got here.
It’s many centuries ago, and you’re a man that just came into some gold. You’re filled with fear, because you know that there are vandals and relatives on the loose who could just come in at any time and divest you of your gold chest. You could bury it, but then you’d have to dig it up every time you wanted to go all bawdy on a desirous maiden. Or you could hire a guard – but who to trust, eh?
What about the goldsmith? That guy has hired henchmen of a muscular persuasion. And if they weren’t trustworthy, he’d be effed already. I mean – look at them. And that one has a two-sided axe. Woah.
So you talk to the goldsmith, and he agrees to hold your gold, and give you a promissory note for it, in exchange for a small storage fee (the very first bank charge).
Over time, the goldsmith starts to accumulate a lot of gold. And he empirically observes that the world is divided into two types of peoples: hoarders and spendthrifts. And the hoarders never seem to use their gold; and the spendthrifts are all too keen to use it.
Why not lend the spendthrifts some of the gold that the hoarders aren’t using? The hoarders will never know – because they’re unlikely to ask for it. And I can charge the spendthrifts a small facilitation fee for the use of the gold (the very first interest charge)!
Awesome. Only – his goldsmith cousin sees what he’s doing (what with all the “loan shark” posters hammered to his door) – and realises that if he’s willing to charge less of a storage fee, he can still make money! In fact, if he pays the hoarders for depositing their gold with him, he can still make money.
So birthed the bank:
But the story wasn’t quite complete (much to the soon-to-be-delighted goldsmith’s delight). Because the next question is: what does the borrower do with his money? He uses it to buy stuff. And whoever gets that money either uses it or needs somewhere to put it – so the gold eventually always ends up in the hands of a hoarder!
And the goldsmith realises that the hoarders now have even more money that they’re unlikely to need anytime soon, so he lends it out. And it comes back. And he lends it out. And…
Abracadabra: the fractional banking system as we know it. And some absurdly delighted goldsmiths who are no longer even remotely interested in making gold trinkets.
The Banking Crisis
This whole banking lark looked like a win-win situation for everyone. The depositors generated wealth, the borrowers got to build their businesses until they too became net depositors, and the goldsmiths were making plenty of money off the money.
So when one day, enough depositors got panicked about the goldsmith’s reliability, and asked for all their gold back (the first bank run!), everyone was like:
The Capital Requirements Rule
So the kings, emperors and/or governments got involved. And instead of banning lending altogether, they decided that they needed to answer this question:
“How much physical gold does a goldsmith need to have on hand at any one time so that he’s got enough to cope with a regular-sized bank run?”
And that’s quite a clever question: because higher reserves don’t just mean better coverage for the banks, it also means less deposits for them to cover. The principle is called the reserve ratio multiplier. And it goes something like this:
- If the reserve ratio is 50%, and I receive $100, then the bank can lend out $50. And then a further $25 when the $50 gets re-deposited. And so on until the bank ends with $200 of deposits and $100 of loans (and $100 of cash in reserve!)
- If the reserve ratio is upped to 75%, then the bank can only lend $25 of the initial $100 out. And then $6.33 when that $25 gets re-deposited. And so on until the bank ends with $133 of deposits and $33 of loans (and $100 of cash in reserve!)
- The higher the reserve ratio, the less “money” there is floating around, and the better covered is the bank (same reserves for fewer deposits).
In the modern world, we’ve moved off the gold standard. So now it’s not “gold reserves” – it’s capital reserves. Which got the bankers very excited, because now they started to ask:
“Well what counts as a capital reserve?”
And some bankers said “let’s use government bonds”, and other bankers said “we can also use shareholders’ capital”. And then this turned into a conversation about whether shareholder capital is the same as a government bond – and the solution involved weighting those two differently when calculating reserve ratios (risk-weighting).
So what is Basel?
Basel is a town in Switzerland, and it is home to the Basel Committee for Banking Supervision. This committee has set guidelines for:
- how to calculate a bank’s reserve requirement;
- what can be included as a reserve;
- when to risk-weight those reserves; and
- what is a reasonable reserve ratio.
There have been two sets of Basel requirements so far – both issued in response to a new banking crisis. The third set (Basel III) has come about in the wake of the most recent financial crisis (where we re-learned the lesson that no asset is riskless). And it’s a bit of a compromise in many ways, because there’s lots of risk-weighting and so on.
The Senatorial Argument
- This whole business has too many loopholes.
- There is no substitute for share capital.
- It’s going to a 15% requirement, not “this 4.5% Basel III story”.
- We cannot continue to allow the goldsmiths to decide how much gold they need to keep on hand.
- Because, like, history.
- So, no.
- Just no.
***Two years out of Cape Town, and they still know me by name. That. That is service.
****My cultural reference to Senators Barney Frank and Chris Dodd, who were responsible for getting the Dodd-Frank Wall Street Reform and Consumer Protection Act passed in the wake of the subprime crisis. It’s a LONG piece of legislation, still under dispute, that regulates almost everything that JP Morgan CEO Jamie Dimon wants to do. PS: it’s been criticised for being an almost-entirely Democrat piece of regulation. I maintain that’s because Barney Frank is openly gay and married to his partner. I mean – what’s the GOP to do? Talk to him? Hells’ bells.