Banking

Banking makes a major contribution to mature economies but banking crises can do them great damage. Bank regulation is a compromise between the avoidance of banking crises and the preservation of banking efficiency. Following the crash of 2008, proposals for regulatory reform are under consideration, and there are prospects of major changes to the structure of the world's banking industry.

Overview

Banks can encourage enterprise and innovation by transferring resources from those who own them, but do not wish to use them, to those who wish to use them, but do not own them; and by transferring risks from those who wish to avoid them, to those who are willing to accept them. There is no reason to doubt that by performing those functions, they have made major contributions to the growth of the prosperity of their communities. Also, there is little doubt that their contributions have been significantly enhanced by the many innovations that they have adopted over the years. The banking practice of financing long-term loans with the proceeds of deposits that can be withdrawn at short notice is inherently risky, however, and it can continue only so long as those who put money in a bank remain confident that they can get it back. Inability to preserve that confidence has been the cause of hundreds of bank failures and, because one bank failure can precipitate the failures of others, it has also been the cause of national banking crises. Moreover, because of the growth of international financial transactions, a banking crisis in one country has sometimes been known to infect the banking systems of others. The globalisation of financial transactions that developed throughout the twentieth century, has finally resulted in the possibility that a local banking crisis in one country could result in the collapse of banking systems throughout the developed world.

The counterpart of the contributions made by the banks to the prosperity of their communities has been the dependence of their communities upon the availability of banking services. In the extreme case of a sudden withdrawal of all banking services, a community could suffer losses comparable to the effects of a natural disaster. To avert that danger, governments have been willing to rescue any bank, the failure of which could precipitate a national banking crisis. By doing so, however, they have provided other large banks with a motive to take risks that they would otherwise avoided in the belief that the government would protect them from the worst of any disastrous consequences. Bank recues have thereby tended to increase the likely need for further rescues. So. to counter that tendency, governments have usually imposed restrictions upon bankers' conduct and have required banks to hold reserves of cash large enough to tide them over any foreseeable misfortune. Those requirements may have reduced the efficiency and profitability of banking, to have led to the creation of organisations that can supply banking services without having to comply with banking regulations, and to have prompted banks that can do so to relocate to jurisdictions with less onerous regulations.

Supplementary material

The following supplementary material is available on the subpages:

• a banking glossary;
• links to reports of major events; and,
• notes on leverage and money creation.

Banking essentials

Commercial (or "retail") banks accept payments from depositors and lend money to personal and commercial borrowers. In addition to the money they get from depositors, they can borrow money in a variety of ways, including short-term loans from their central bank's "discount window", or from the money market. They make profits by charging higher interest rates to their borrowers than they pay to their lenders.

The banks that lend money to borrowers but do not accept deposits from the public, include wholesale banks that deal with other banks or financial companies; investment banks, (also known as "merchant banks") that raise money for companies by finding buyers for their equity and bonds; and "universal banks" that combine all of those activities. Other institutions that lend money to personal or commercial borrowers are referred to collectively as the shadow banking system.

The practice of retaining only a fraction of its deposits as reserves and lending out the rest is known as fractional-reserve banking, and it enables the bank to participate in the process of increasing the amount of money in circulation, that is known as the money supply.

Banking theory

Bank runs (the Diamond-Dybvig model)

Banks usually make loans that they cannot withdraw at short notice, and pay for them with deposits that can be withdrawn without notice. This is referred to as a situation in which a bank's liabilities are more liquid than its assets. A bank is said to suffer a liquidity crisis if too many depositors attempt to withdraw their money at one time - a situation referred to as a bank run. The Diamond-Dybvig model explains why banks choose to issue deposits that are more liquid than their assets and why banks are subject to runs. It is a highly stylised three-period, one-bank construction that makes use of the game theory concept of a Nash equilibrium to derive its conclusions. . The model has been widely used as theoretical framework for analysing the economics of banking and banking policy

Bank lending (incomplete contract theory)

When it is not feasible to provide in a contract for all of the circumstances that may govern its fulfilment, the contract is said to be incomplete. There is often a tacit understanding that the terms of an incomplete contract may be renegotiated if there any unexpected developments. The concept of an incomplete contract is applicable to a bank loan because it is always possible that circumstances will arise under which the recipient may be unable to comply with its terms. Under those circumstances, renegotiation may be better than bankrutcy, both for the bank and for the borrower. It can be argued that it is the incomplete contract concept that has thus distinguished bank loans from other forms of borrowing. There is no established mechanism, for example, for the renegotiation of the terms of a bond.

Incomplete contract theory is about the economic advantages that can arise from the flexibility provided for in an incomplete contract. The theory has also been used to explain the historical development of banking practice and to make suggestions concerning its future development .

The agency problem

A problem can arise when an agent, who is employed to look after the interests of a principal, uses for his own benefit the authority given to him for that purpose. The agency problem is the problem of deciding how much it is worth spending on precautions or incentives to discourage such behaviour. Principal-agent relations are a necessary feature of financial intermediaries and conflicts of interest are inevitable. Market forces may be expected to deter agent misbehaviour when the principals are as well-informed as their agents, but communication difficulties give at least temporary protection to misbehaving agents in the complex context of modern banking. A wide range of potential agency problems has been identified , and there have been extensive studies of the influence of pay incentives such as performance-related bonuses. However, the perception that performance-related bonuses could encourage investment managers to take unwarranted risks was not voiced until 2008.

Portfolio theory

Applications of financial portfolio theory as a means of risk limitation had an important influence on banks' investment policies. It led to the development of the concept of value at risk which had its origins in the 1922 membership requirements of the New York Stock Exchange and has since been developed over the years by the incorporation of successive developments in financial economics. Its common feature is the assumption that investment risks are stochastic rather than deterministic - that is to say, the assumption that they arise from the existence or random fluctuations, and not as a consequence of human behaviour.

The supply of money and credit

The creation of money

With the development in the 20th century of "fiat money" - whose value derives solely from the authority of government - the banking system has come to play an essential part in influencing the money supply. It can be shown that a bank that lends out all but a fraction of its deposits can actually create money, so that, for example, a bank with a ten per cent reserve ratio can convert a £1000 deposit into an increase in the availability of money of up to £10,000, effectively creating money. The extent to which banks do so in practice depends upon the extent to which money that is borrowed from a bank is returned to the banking system as a deposit. It depends also upon the banks' reserve ratios. In times of strong economic growth, the banks tend to increase their lending with the result that they encourage more investment and consumption. Conversely, there is a tendency to reduce their lending (or "deleverage") in times of recession, causing a reduction in the availability of money (in extreme cases, creating a "credit crunch") - a practice that tends to worsen the recession.

Monetary policy

The task of managing its currency is usually delegated by a country's government to its central bank and with it, the responsibility for maintaining monetary stability. The adoption of monetarist theory in the 1980s led to attempts to control inflation by controlling the money supply. One way of controlling the amount of money in circulation is by varying the discount rate that it charges for loans to the banks. A discount rate reduction encourages banks to borrow money so that they can increase lending and so create more money. Another way of increasing the money supply is by open market operations in which the central bank buys securities from the private sector, paying for them by a nominal increase in its balance sheet liabilities quantitative easing, sometimes referred to as "printing money"). Alternatively, the money supply can be increased more directly by reducing the minimum reserve ratios that the banks are legally required to maintain. It is also open to a central bank to sterilise the monetary system against other influences upon the money supply by increasing or reducing its holdings of government securities. However, the degree of control that can be achieved by any of those methods is limited by the fluctuations that occur in the demand for money. Current monetary policy uses the central bank's influence on interest rates rather than the money supply, either to limit inflation at times of rapid economic expansion or to stimulate growth in order to avert a recession, and qualitative easing has only been used during major recessions (it was used in Japan in the 1990s and in the United States and Europe in 2009).

The benefits of banking

There is a presumption that - by providing an improved conduit between savers and investors - banking makes a significant contribution to the functioning of an economy. The improvement that it provides is generally attributed to the banks' screening of applicants for investment funds, to their mobilisation of savings, to their monitoring of investment projects, and to their allocation of risks in response to the needs of different categories of investors. Despite measurement difficulties, the consensus view among economist is the belief in the economic benefits of banking is well supported by empirical evidence - even to the extent of suggesting that a well-functioning banking sector may be a necessary precondition for economic growth. Studies of the Dutch Republic, England, the U.S., France, Germany and Japan suggest that the establishment of a financial system has always preceded the onset of economic growth, and a correlation between financial developments and economic growth over the period 1850-1997 has been established by a cross-section study of 17 countries. It has also been shown that countries with more sophisticated financial systems tend to engage in more trade, and appear to be better integrated with other economies. . Other empirical investigations have shown that the ratio of banking liabilities to GDP is strongly correlated with economic growth .

The costs of banking

Like any other enterprise, a bank can increase its profitability by increasing its leverage. A bank creates leverage when it lends more money than it holds as reserves but, because of the arithmetic of leverage, that practice increases its vulnerability to financial losses even if they are temporary. With leverage ratios commonly as high as 20, losses of over 5 per cent can be sufficient to create insolvency. For a bank, the principal risks of loss are credit risk, which is the risk that the value of a bank's loans will fall as a result of defaults on the part of borrowers, and interest rate risk, which is the risk that the value of a fixed-rate loan will fall as a result of a rise in interest rates. In common with other enterprises that make profits by financing long-term investments by short-term borrowing, banks are also vulnerable to liquidity risks. Deposits in banks that can be withdrawn on demand are, in principle, the same as short-term borrowings, although in normal circumstances it is unlikely that any substantial proportion of them would be withdrawn simultaneously. Should that happen, however, the bank may find itself unable to raise the money needed to pay its depositors. A run on a bank can happen if depositors lose confidence in its ability to repay all deposits in full, and try to withdraw their funds immediately. A liquidity crisis or a bank run can drive an otherwise solvent bank into insolvency as a result of losses on the resulting forced-sales of its assets .

The costs of a bank's failure may not be confined to its shareholders. A loss of confidence in one bank can spread to other banks by a process termed contagion. It may affect only those banks that are considered to face similar problems, but it may become a panic and affect banks that would otherwise be considered trouble- free - and, under extreme circumstances, it can lead infect non-banking organisations and lead to a systemic failure of a country's financial system, or even of the world's entire financial system.

Banking innovations

Medieval banking

A variety of enterprises whose activities can be broadly described as banking were in existence before and during the middle ages. Some, that have been categorised as "deposit banks", accepted deposits and made loans; some, termed "exchange banks" were restricted to providing the means of making transactions between traders using different currencies; and others combined both functions. Deposit banking is believed by historians to have evolved from money changing. Coins were displacing barter as a means of trading but since they were of variable quality, it is thought to have been convenient to use the services of a money-changer. A trader could open an account with a money-changer into which he could deposit and withdraw coinage. Payments to other traders with accounts with the same trader could then be made by having the money-changer debit his account and credit theirs. The money-changer had to keep some coins in reserve for withdrawals and payments to other money-changers but since, with random inflows and outflows, a net outflow amounting to a major proportion of the money deposited was unlikely, the otherwise idle cash was made available for loans. Those loans usually took the form of overdrafts to depositors because they were considered less risky than loans to strangers. The main causes of bank failures were fraud, and defaults on loans made to kings to pay their armies .

Renaissance banking

Few European banks achieved a reputation for probity and stability before the 17th century, mainly because of the absence of established property rights or of the effective discouragement of fraud. There were a few local attempts to create stable and reliable banks. For example, the municipal authorities in Barcelona set up a public bank in the late fourteenth century, which accepted deposits but was not authorised to make loans to the public , but elsewhere banking fraud and financial failure were commonplace. The best-known among the few exception was the Medici bank, which flourished in Florence in the first half of the fifteenth century, surviving long enough to develop some significant innovations. In particular, it brought about the general commercial use of "bills, of exchange" (which are the banking counterpart of promissary notes or IOUs), which enabled traders to defer payment for a purchase . Its practices are thought to have served as the model for modern European banking.

Innovations in the 17th and 18th centuries

In the early years of the 17th century, the municipal authorities of Amsterdam, became aware that commercial activity there was being hampered by the uncertainties created by the circulaton of coins of various currencies and differing quality and, as a corrective they founded the municipally-controlled "Wisselbank" . The Wisselbank operated mainly as a service to merchants and it did not make loans to the public. Apart from its currency function, its main contribution to banking innovation was a system of transfers by cheques and direct debits that was similar to the system in use in the 21st century. It has been credited with pioneering the practice of a limited form of fractional-reserve banking and the practice of open market operations, and with performing some of the functions of a modern central bank. However, the claim to have been the world's first central bank is made by the Swedish Riksbank which was inaugurated 1668 as the successor to John Palmstruch's "Stockholm Banco". It was nominally a private bank, but the King of Sweden appointed its management, and regulated its operations. It issued loans, and maintained reserves at only a fraction of its deposits. Its main contribution to banking innovation was the issue the first modern banknotes, which were interest-free bills of exchange, denominated in specific amounts and - in principal - corresponding in total value to money deposited in the bank. It was later to be formally recognised as a public bank with a statutory monopoly of the issue of banknotes .

The Bank of England was created as a private bank in 1694 , mainly in order to raise money for the government of the day (by converting some of its debt to shares in the bank and in 1709 it was granted a partial monopoly in the issue of banknotes. . . The bank maintained sufficient reserves of gold to redeem its notes on demand (except during the Napoleonic War, when that facility had to be suspended). An attempt was made to set up a French central bank in 1710, but after a successful start, it collapsed in 1720, causing a major economic crisis. .

United States banking commenced in the 1780s with the chartering of the Bank of North America, and the creation of the First Bank of the United States .

Expansion and instability in the 19th century

The Bank of England became the biggest British bank and its discount rate came to be recognised as the minimum short-term interest rate in the money market and the Bank Charter Act of 1844 established it as the only institution in England with note-issuing powers. The lifting of restrictions on joint-stock banking in 1858 led to the emergence of major commercial banks including Barclays, Lloyds and National Provincial and investment banks including Barings and Overend Gurney. There were banking crises in 1847, 1857 and 1866 in the last of which the Gurney-Overend bank collapsed, causing a panic in which large numbers of people tried to withdraw deposits from their banks; leading to the collapse of over 200 companies . On that occasion the Bank of England had refused to help, but the influential commentator Walter Bagehot urged that in a future panic it should "advance freely and vigorously to the public out of its reserves" in order to avoid another "run on the banks", a recommendation that is credited with the esablishment of the concept of the central bank as lender of last resort . In 1890 the Barings bank, then the world's largest investment bank, failed and a rescue was organised by the Bank of England signalling its acceptance of responsibility for the stability of the banking system, and from then on it gradually assumed in full, the role of a modern central bank..

Elsewhere in Europe, the nineteenth century saw the emergence of major investment banks in Belgium (Société Générale), France (the Crédit Mobilier) and Germany (the Damstädter bank), and, as in Britain, deposit taking was concentrated in a few large private companies. European and other industrial economies except the United States followed the British example and created monopolistic central banks. The Banque de France was established in 1800, the German Reichsbank in 1875, and the Bank of Japan in 1882.

In the United States the 1864 National Bank Act encouraged the creation of privately-owned banks, capital requirements were set low by European standards , and there began a rapid expansion of an effectively unregulated banking system and a long period of intermittent financial instability. A large number of small banks sprang up at the state level, but few of them survived for more than five years and there were also major failures at the national level. There was strong Congressional opposition to the establishment of a central bank on European lines and runs on the banks became a regular feature of American economic life.

The 20th century

Following the banking panic of 1907 the United States Congress created the Federal Reserve System and granted it powers to assist banks that faced demands that they would otherwise be unable to meet. In the course of the early twentieth century, it assumed the role of lender of last resort and was to provide short-term loans to solvent banks to tide them over temporary liquidity difficulties and also to arrange longer-term loans to avert failures that would be large enough to threaten the stability of the banking system. After the American stock exchange crash of 1929, there was a substantial reduction in the profitability of the banks and in 1930 a series of bank failures in the South and the Midwest led to attempts by depositors to convert their deposits into cash. The failure of the "Bank of the United States" created a general mistrust of the banks, leading to the more severe 1930s banking crises and by 1933, there were bank failures involving nearly half of the banks that had existed in 1929, and most of the rest had suffered heavy losses. The loss of nearly half of the banking system and the depleted reserves of the remainder led to what is now called a credit crunch, and the financial system was further disrupted by widespread defaults among mortgage holders and by insolvencies among small firms. Confidence was restored by a government undertaking to insure depositors in banks against loss that was administered by the newly-created Federal Deposit Insurance Corporation after which there were relatively few further banking failures until the 1980s.

Following the banking deregulations of the 1980s there were major changes to banking practices throughout the banking world . The most significant of the banking innovations that were then introduced was the practice of securitisation, meaning the conversion of their loans into graded packages of bonds; and the development of the strategy known as originate and distribute, under which such bonds were sold to pension funds, insurance companies and other banks. . Banks had previously financed their lending mainly by deposits from their customers, but that practice was being replaced by the practice of converting mortgages into graded securities and selling them on the bond markets and some were also raising money on the money markets - practices that made possible a massive increase in mortgage lending. Bank mortgages came to account for a substantial proportion of a market that had previously been dominated by the government-sponsored agencies (Fannie Mae and Freddie Mac) , and mortgage-related bonds came to occupy an important place in the bond market . The profitability of dealings in the new derivatives encouraged a massive growth in the shadow banking system which consisted of organisations such as hedge funds that performed banking functions but were not required to submit to the restrictions of the banking regulations. The profitability of trading in the derivatives markets was enhanced by the use of high levels of leverage. As noted in the addendum subpage, there had already been a substantial reduction in banking reserve ratios since the nineteenth century and banks had long been able to acquire liabilities of up to 20 times their share capital. Some hedge funds had even been known to invest up to 30 times their share capital, a practice that played a part in the downfall of "Long Term Capital Management" . Some hedge funds were in effect the subsidiaries of investment banks under arrangements that committed the banks to their support, creating liabilities that were not revealed in their published balance sheets.

The 21st century

In the autumn of 2007, after a six-year boom, in the course of which prices rose by up to 70 per cent, , the United States housing bubble burst, leaving many mortgage holders owing more than their houses were worth. The multiple mortgage defaults in the ensuing subprime mortgage crisis created a loss of confidence in holders of mortgage-related assets, and there were multiple bank failures in 2008, including, in March 2008, Bear Stearns (a major US investment bank) was rescued from bankruptcy as a result of losses by its hedge fund subsidiaries, and in the following September, Lehman Brothers (another major US investment bank) declared itself bankrupt, triggering the crash of 2008, a panic that threatened the collapse of the international financial system. The responses by national governments and central banks then, and in the course of the recession of 2009, included bank rescues, fiscal stimuluses, discount rate reductions and quantitative easing.

The consequences of the banking innovations

The banking industry's efficiency as a conduit through which resources are conveyed from lenders to borrowers was greatly enhanced by the introduction in the early 17th century of the practice of fractional-reserve banking; and again in the late 20th century by the introduction of the practice of originate and distribute. Its stability was enhanced by the creation of central banks and their assumption, in the 19th and early 20th centuries, of responsibility for its supervision and and regulation, by the introduction of deposit insurance in the 1930s, and by the rescues of banks that had become "too big to fail". It may be assumed, however, that the resulting gain in stability was partially at the expense of the efficiency gains. It may also be supposed that some of those losses were recouped as a result of the deregulations of the 1980s. It only later became apparent that the protection accorded to the banks by some of the measures taken to increase their stability has created a moral hazard because it enabled them to "privatise gains and socialise losses" , but the full consequences of the resulting threat were not immediately apparent. Some observers were aware by 2005 that decisions that had previously been taken by managers on fixed salaries were being taken under the originate and distribute regime by traders who were being awarded profit-related bonuses that were unrelated to the risksiness of their decisions, and that the decisions of those traders were being further distorted by the fear of being outperformed by their rivals - but it was generally assumed that the moral hazard problem would be effectively encountered by the implementation of the recently revised recommendations of the Basel Committee.

Banking crises

Overview: Systemic failure

From an economic standpoint, individual bank failures need not be a cause for concern because they may be no more than a reflection of the fact that risk-taking is an unavoidable feature of banking; and because the market positions vacated by those banks that do fail because of bad management may be taken up by better-managed rivals. But the simultaneous failure of a group of banks is a different matter because it may constitute a "systemic" threat, arising from the damage caused to other financial and non-financial enterprises. Failures that result in a major reduction of a country's banking capital almost inevitably result in a systemic crisis as the remainder of the system falls victim to positive feedback because the economic damage done by initial failures results in the failure of banks that would otherwise have prospered. Positive feedback from an economic recession may similarly lead to systemic banking failures that further exacerbate the originating recession .

The Asian banking crisis

Banking crises in 14 countries in East- and South-East Asia in the period 1980 to 2002 resulted in output losses estimated to average 22 per cent . Japan was the hardest hit. Credit risks stemming mainly from non-performing real-estate loans led to the closure by its deposit insurance authorities of 180 deposit-taking institutions and an output loss estimated as 48 per cent of GDP. Popular opposition made the government reluctant to make direct use of taxpayers money for general assistance to the banking system, and the banking crisis dragged on for over eight years .

The Scandinavian banking crises

The banking crises in Norway, Sweden and Finland in the 1990s have been attributed mainly to credit risks resulting from an increase in non-performing loans as economic conditions deteriorated following sharp tightenings of monetary policy . They resulted in substantial output losses and increases in unemployment, but they were eventually resolved by government measures that in many cases included guarantees to bank depositors and creditors as well as injections of capital. The Swedish government's responses, in particular, have been regarded as a model that other governments should emulate .

The crash of 2008

During the eighteen-month period between the middle of 2007 and the end of 2008 there was a series of financial collapses including the failure or enforced rescue of fifteen major banks, three of the world's largest mortgage-lenders and one of the world's largest insurance companies, and in the Autumn of 2008 there was an international credit crunch that was generally attributed to a loss of mutual confidence among banks prompted by the unexpected failure of the United States authorities to save the Lehman Brothers bank from bankruptcy. According to the Bank of England "The global banking system experienced its most severe instability since the outbreak of World War I" .

Banking regulation

Overview

When a government considers proposals concerning the regulation of its country's banks, it may have regard to the range of compromises between banking efficiency and the security of its banking system that are available to it, and in choosing among them it may also be influenced by its political ideology. In the latter years of the 19th century, security received increasing attention in most industrialised countries, but comparatively little attention was given to it in the United States until the banking crises of 1930-33, after which the uppermost consideration was the need to guard against the repetition of such a disaster. In the 1970s and 1980s, however, there was growing opposition to government regulation. Economists of the Chicago school were arguing that the economic regulation of largely competitive markets had large costs but yielded no benefits - a conclusion that accorded well with the libertarian views of Ronald Reagan in America and Margaret Thatcher in Britain, and they introduced banking deregulation measures that were widely emulated. The wave of bank failures that followed led to the adoption of strengthened banking regulations, but the events of the crash of 2008 proved them to have been ineffective and a consensus emerged in favour of a new internationally-coordinated regulatory regime.

The 19th century

In the 19th century, governments became increasingly aware of the danger that a loss of confidence following the failure of one bank could lead to the failure of others, and eventually to failures elsewhere in the financial system. To limit that danger, they required banks to limit the extent to which their loans exceed the funds provided by their shareholders by the imposition of minimum "reserve ratios" and had placed various other restrictions upon their activities. Those attempts to maintain stability had limited success. In the United States there was a protracted series of politically controversial and mainly unsuccessful attempts to regulate its rapidly expanding banking sector. At the state level, banks had to be registered with state legislatures, who set reserve requirements that were, at best, loosely enforced; and regulations intended to establish a stable banking system at the national level also turned out to be unsuccessful . In England, the collapse of the Gurney-Overend bank also prompted calls for regulation.

The 20th century

Regulation

Following the banking panic of 1907 the United States Congress created the Federal Reserve System and granted it powers to assist banks that faced demands that they would otherwise be unable to meet . The subsequent practice of central banks in the United States and elsewhere has been to assume the role of lender of last resort and provide short-term loans to solvent banks to tide them over temporary liquidity difficulties , and also to provide or arrange longer-term loans to avert failures that would be large enough to threaten the stability of the banking system. The next important innovation was prompted by the sequence of bank runs and failures that occurred in the period from 1929 to 1933. The Glass-Steagal Act of 1933, established the Federal Deposit Insurance Corporation, with authority to regulate and supervise state banks outside the Federal Reserve System and provide them with deposit insurance. The Act also prohibited combinations of commercial and investment banking. and other restrictions were also imposed upon banking activity by a succession of legislative measures. The Glass-Steagall Act introduced measures to protect depositors from risks associated with securities transactions by prohibiting commercial banks from participating in investment banking activities and from collaborating with full-service brokerage firms Restrictions upon banking activities - intended to reduce the danger of a recurrence of the financial instability experienced in the early 1930s - were imposed by most other industrialised countries. Until the 1980s, investment banks were not normally permitted to undertake non-financial activities, nor other financial activities such as branch banking, insurance or mortgage lending.

Deregulation

The thinking of economists of the Chicago School about banking regulation was summarised by Professor Kroszner (a member of the Presidential Council of Economic Advisers, and former Governor of the Federal Reserve Board) in these words:

"...the banking system may be less fragile than is generally considered ... much of the modern instability of banking may be attributable to safety net regulations that purport to mitigate it."

- and Marcus Miller (an even more eminent Chicago School economist) dismissed the case for regulating derivatives . There was widespread political assent to their proposals and Banking regulations were relaxed in the United States and in many other industrialised counties . There was a general relaxation of reserve requirements and restrictions that had prevented banks from combining investment banking and commercial banking activities were relaxed or abolished. In the United States the impact of the Glass-Steagall Act was progressively reduced by a succession of Supreme Court interpretations and was finally repealed by the Gramm-Leach-Bliley Act in 1999 . The impact of regulatory relaxations gradually became apparent and a 2004 study for the Bank for International Settlements later concluded that deregulation had left Spain, Norway, Sweden and the United States with regulatory systems that had been ill-prepared for the banking crises that they then encountered .

Basel I

In 1974 the governors of the central banks of the Group of Ten leading industrial countries had set up The Basel Committee for Banking Supervision to coordinate precautionary banking regulations , and in 1988, concern about the increased danger of systemic failure led that committee to publish the Basel I set of regulatory recommendations that related a bank's required reserve ratio to the riskiness of its loans . It first defined two "tiers" of capital, one of which it termed "core" or "tier 1" capital (equity capital and reserves from post-tax retained earnings) and set limits upon the other that items could be treated as bank capital. Then it assigned weights to various types of bank loans (which were termed assets) according to what it deemed to be their riskiness. Finally it stipulated a minimum ratio of capital to risk-weighted total assets of 8% (and that of core capital element of 4%).

The 21st century

Pre-crash regulation

In 2004, the Basel Committee published revised recommendations known as Basel II that allows banks to use their own measures of credit risk and convert them into risk weights using stipulated formulas. As well as specifying capital requirements, it provides a detailed specification of the supervisory methods to be used by the banking regulators, and of disclosure requirements to be met by the banks. In September 2008, the committee published its recommended principles of liquidity management that require banks to adopt policies determined by the construction and stress testing of cash flow projections, and stipulate the relevant responsibilities of their regulatory authorities.

Post-crash proposals

In July 2009 the Basel Committee issued proposals to "enhance" Basel II , that require banks to rely upon their own risk assessments rather than those of the credit rating agencies, and that include revisions that have been taken to imply that a typical bank should maintain its core equity capital at 8 to 9 per cent of risk-adjusted assets, which would be reduced to 4 per cent during a crisis .

In December 2009 the Basel Committee published consultative proposals designed to further strengthen the system, that included improved liquidity management procedures and the maintenance of "contracyclical" reserve ratios that rise and fall in response increases and reductions in economic growth rates.

Post-crash regulation

In 2009 the United States Congress passed the "Wall Street Reform and Consumer Protection Act", which created a Consumer Protection Agency and a Financial Stability Council; provided for the dismantling of large failing financial institutions, and introduced new regulations for the regulation for mortgages, credit rating agencies, hedge funds and private equity companies, and trading in derivatives.