Banking stability and the Basel capital standards.

• Author: Rodriguez, L. Jacobo

In thinking about bank stability and the Basel Accord, rather than concentrating on whether the Basel Committee has gotten every little detail of the new Accord right--a task that can greatly affect banks' bottom lines--it is more appropriate for our present purposes to concentrate on some more general--and perhaps fundamental--questions. (1) How successful has the original Basel Accord been in accomplishing its stated goals? How successful will Basel II be in accomplishing those goals? Are those goals desirable? And perhaps the most fundamental question of all: Is the Basel Accord that is, the international harmonization of capital standards--necessary or desirable to have a stable financial system?

Theoretical and Historical Background

In 1988 the Basel Committee on Banking Supervision completed the Basel Capital Accord after years of deliberations that followed the Latin American sovereign defaults of 1982. The Basel Accord was established with two fundamental objectives: to strengthen the soundness and stability of the international banking system and to obtain "a high degree of consistency in its application to banks in different countries with a view to diminishing an existing source of competitive inequality among international banks" (Basel Committee on Banking Supervision 1988). To that end, the accord requires that banks meet a minimum capital ratio that must be equal to at least 8 percent of total risk-weighted assets.

The Basel Committee on Banking Supervision concentrated on capital standards for two reasons: first, because Congress instructed banking regulators to work with regulators from other countries to make sure that banks had adequate capital bases (Kapstein 1991, Oatley and Nabors 1998); second, because capital serves as a buffer that protects bank deposits--or the deposit insurance fund--in case of losses on the asset side.

Are Banks Special?

Traditionally, banks and other providers of financial services have been subject to greater government regulation than most other sectors of the economy. Regulation of banks has historically come in the form of entry restrictions, limits on activities, geographical restrictions, reserve requirements, and capital requirements (Benston 1998: 18, 27-85; Kroszner 1998: 421; Kane 1997; Goodhart et al. 1998: chap. 9). Today, most regulation falls under the rationale of either consumer protection or safety and soundness considerations.

University of Chicago economist Randall S. Kroszner, among many others, argues that the main reason for government regulation of financial institutions has been to finance wars (Kroszner 1998: 419). But there has also been a long tradition among economists that goes back to at least Adam Smith who maintained that banks are different from other firms by the very nature of their activities--and because of that, some kind of regulation and supervision is justified.

Smith, of course, was alluding to the inherent instability of banks operating in a fractional reserve system, which, if true, merits their regulation (Smith [1776] 1937: 285, 308). Banks are financial intermediaries that take in deposits, which they then use to make loans and to invest in marketable securities and other financial assets. In the process, for the system as a whole, there is a multiple expansion of the money supply. Because banks' liabilities (i.e., the deposits they take in) are usually fixed in value and payable on demand, while banks' assets (i.e., the loans they give out and the securities in which they invest) are of variable value and not collectable on demand, it has generally been believed that banks are prone to failure and runs--the sudden withdrawal of funds by a large number of depositors who have lost confidence in the bank. In turn, this has the potential of negatively affecting solvent institutions through a contagion effect, which could adversely affect the entire financial system. This is the main justification for the regulation of the banking industry today.

Bank Runs and Federal Deposit Insurance

A fractional reserve banking system, in which banks loan out all or part of their deposit liabilities, is theoretically fragile and prone to runs if depositors have incomplete information about the bank's activities and financial health (i.e., if depositors are unsure about the safety of their deposits and the bank's ability to return those deposits to them on demand). (2) Furthermore, a run on an individual bank could theoretically have destabilizing effects on other banks.

However, the private sector has traditionally been quite adept at dealing with this fragility and, before government-sponsored deposit insurance, took numerous steps to address it. First, banks would disclose their levels of capital to investors and depositors to put them at ease about the safety of their investments and deposits. Indeed, as Emory University economist George Benston (1998: 39) states, "Banks used to advertise prominently [in newspapers and inside their branches] the amount of their capital and surplus." It is worth noting that those levels used to be considerably higher than they are today. (3) Second, investors and depositors used to monitor the activities of banks and demand higher rates of return on their investments or higher interest rates on their deposits if they deemed that their banks were taking on investments that were too risky. Third, before government-sponsored deposit insurance, banks created private clubs and clearinghouses to help one another. Membership in those associations was restricted to those banks that met certain requirements with regard to levels of capital, activities of the bank, and risk profiles (Timberlake 1993: chap. 14). Fourth, banks had "option clauses" in their contracts that allowed them to suspend payments for a specific period in exchange for a higher rate of interest on the debt whose payments had been suspended. Those clauses, widely used in the Scottish free-banking period of the 18th century, had the effect of stopping panic runs and provided banks with breathing room to reorganize their assets without having to engage in fire sales. Finally, bank debt holders often signed covenants with banks that restricted the activities and investments in which banks could participate.

Market discipline by depositors and shareholders worked rather well to prevent runs and, when those occurred, to prevent them from spreading to other banks. Bank failures in the United States were on average lower for the period between the end of the Civil War and the end of World War I than those for nonfinancial firms. Furthermore, those banks...