Economic world remains confused

(On capital reserves requirements and other regulations)

The recently published report by John Kay, "Narrow banking: the reform of banking regulations" shows that the financial and economic world is confused about banks’ capital reserves requirements. Let us start with an example.

In world of energy resources there is a parallel requirement in terms of holding adequate reserves of various energy sources. Typically, subject to energy industry structure, a country needs to hold sufficient reserves of crude oil and hard coal. Both sources of energy can be seen as "liquid" between each other. In the world of science the equivalence is in energy units. However in the world of trading the equivalence is in prices. Therefore a country could hold crude oil reserves in coal: in case of shortage of crude oil, a country would sell its coal reserves and buy required amount of crude oil. This would be especially attractive for countries that have massive coal resources and limited crude oil resources.

Despite such appealing "innovative" structure of holding energy sources reserves, no country practices this approach. In fact it would be considered as foolish. When a shortage of crude oil comes, the value of coal is very likely to decrease dramatically to the original equivalence assessment and the energy producers, like refineries, are very unlikely to accept delivery of coal instead of crude oil.

If banks have cash liabilities (and a lot of them are precisely these), the reserves must be in cash and in currencies in which these liabilities exist (Zimdollars would not be good reserves for Norwegian Kroners liabilities, would they?). There is a room for a margin of "reserves" being held in other forms, but these are NOT reserves but investments that attract a certain liquidity risk of not being convertible into the original liability.

John Kay observed in his analysis:

"During the crisis, several banks continued to report compliant capital ratios although the pricing of their equity and subordinated debt indicated that the market believed that they were insolvent."

The business world understands that you cannot keep copper reserves in iron ore, crude oil reserves in coal, or timber reserves in polymers. Similarly, the financial world had also understood for centuries, until a couple of decades ago, that liquidity reserves had to be kept in cash. Fractional reserve banking, with loan to deposit ratio below 100%, in reality below 90%, has been a great risk management achievement: putting more money into economy whilst still keeping adequate cash reserves to cover ongoing liquidity needs.

As pointed out in the "The largest heist in history" and other articles on this blog, in the last couple of decades this system has been turned upside down. Fractional reserve banking was replaced by depleting reserves banking i.e. lending with loan to deposit ratio above 100%, depleting cash reserves by pushing them onto the market (into deposit – loan cycles). This system was possible as financial papers and instruments other than cash were allowed to serve as capital reserves intended to assure banks liquidity. A complete and obvious lunacy: it was like if, in a different industry, timber was an accepted reserve for a polymer stock (or the other way round). It is possible, but only to a very limited degree. The nonsense of such reasoning still seems not to be appreciated in the world of finance, despite the fact that any, even a small investor, knows that the value (i.e. cash value) of financial papers and instruments can go up as well as down. This is despite the fact that until a couple of decades ago, bankers had understood this for centuries.

The liquidity crunch happened a year ago (and still continues) precisely because the banks did not have sufficient cash reserves. The capital reserves were to a massive extent bogus created as a result of a global massive pyramid scheme. (The article "Exercise/example – how does it work?" shows how once well-priced capital becomes bogus in the presence of depleting reserves banking.) It is almost certain that it was a scam premeditated to steal cash for banks' reserves and taxpayers (through bail-outs and subsidies). Of course a lot of bankers were just silly (i.e. criminally negligent), but quite a few of them were crooks who designed, operated (and still operate) this system.

John Kay is not correct in asserting that regulatory requirements proved inadequate (let alone massively inadequate). Laws and regulations of any civilised country prohibit creation and running pyramid schemes such as the one that caused the current crisis. And this is precisely what bankers (with the blessing of regulators and some politicians) were doing. Therefore it is somewhat vacuous to think about knew regulatory framework. Prosecution of all pyramid purveyors that caused this crisis should be an urgent priority.

In this context it is very refreshing to read John Kay's observation: "Financial services activities are particularly attractive to sophisticated criminals. Preventive and punitive activity against fraud is essential". You can say it again, Professor Kay.