Tuesday, 5 May 2009

Banking Regulations

As I see it........ by L. Berney

The collapse of the World’s financial system is blamed on the excessive and irresponsible loans made by the banks. The rules under which banks operate have been proved to be disastrously inadequate. It seems to be universally agreed that when we get out of the financial mess we are in, the rules governing banking operations will have to be re-written.


Banks perform three main functions:
  • A checking or current account function A safe-keeping service for customers’ money and the handling of payments and receipts
  • An interest-bearing deposit function Customers place money “on deposit” with a bank with a specified date for that money to be returned and a specified arrangement for the payment of interest
  • A loan function Granting loans to individuals and businesses, and charging them interest for doing so. As with deposits, the details for the return of the loan and the interest to be paid are specified in advance

In 2008, the world’s financial system collapsed – we now have a world-wide recession. Blame is leveled on the world’s banks because, over the last two or three decades, they lent out too much money too easily.

After the “Wall Street Crash” of 1929 and the “Great Depression” of the 1930s (caused, as now, by excessive bank lending) new banking rules were established which geared the maximum amount banks could lend to the amount of money deposited with them -- the “Cash Reserve Ratio” of the “Fractional Reserve Banking” system. Starting in the 1980s, governments began to relax those rules, to allow the banks to reduce their Cash Reserve Ratios, to lend more. The thinking at the time was that restricting the amount of money loaned was stifling economic growth. By around the year 2000, most banks were “de-regulated” and were free to loan out as much money as they wished – it was left to “the efficiency of the free market” and for the banks themselves to decide how much.

The amounts they loaned escalated. The amount banks that lent out compared to the deposits they held was, on average, as follows:

UK in 1968 loans were 5 times deposits – 1988 20 times – 2008 over 30 times

USA in 1968 loans were 8 times deposits – 1988 12 times – 2008 over 30 times

Germany in 1968 loans were 5 times deposits – 1988 6 times – 2008 over 30 times

This heavily increased lending (and therefore spending) and gave rise to higher than realistic living standards – a BOOM – but a boom based on excessive debt. Due to various reasons – such as fierce competition between banks; lowering of credit criteria (125% mortgages!); belief that property would keep going up; lax management practices; variable mortgage rates, the greed of bonus-earning executives -- loans were made to people and businesses who, in the event of a downturn, had little or no possibility of paying the interest due on their loans.

In the USA in 2007/8, mortgage interest payment defaults started to occur which rapidly led to a fall in property values. Banks stopping further lending, there was a “credit crunch”, and that in turn led to a world-wide economic downturn. The debt bubble has burst and we now have a BUST.


Since the BUST was caused by the banks over-lending, how should the rules under which banks operate be written so that this BOOM-BUST situation does not to happen again? As a Bank of England report says, “...a fundamental re-think of safeguards against systemic risk is needed.” The G20 summit and indeed the whole world now see that the old banking rules are woefully inadequate and that the need to devise a new set of banking rules is essential.

In an ideal world, the economy would be based on, “Live within your means -- you can only have what you can pay for – if you can’t pay for it, you can’t have it”.

However, it is a fact that the economy of our world relies on many people and most businesses being in debt -- having what they can’t pay for.

If loans were prohibited I expect we would all be back to the Stone Age!

I am not a banker but, for what it is worth, I will throw my hat into the regulation ring!

My proposal for new banking rules (bank regulations) would be as follows:


The first requirement is the separation of current banking functions. The functions currently performed by banks would be re-structured. “Banks” would perform current/checking account functions only. Deposit and loan functions would be separated off from our existing banks and would be performed by legally separate commercial entities, “Finance Houses”.


Banks would supply current/checking account services only.
  • Safe-keeping service for customers’ money
  • Money deposited immediately re-payable on demand (cash or bank cheque)
  • Payments to any other bank (debit cards, cheques, bank-to bank transfers, standing orders, etc)
  • Receive cash or transfers from other banks
Banks would have on hand at all times the total of the deposits lodged with them, a banking system known as “100% Reserve Banking”.

Banks would not “use” customers’ money in any way, would not make loans of any kind, would not permit overdrafts, would operate debit cards but not credit cards, would neither pay interest nor charge interest. Their income would derive solely from bank charges.

Each Bank would have an account with the country’s Central Bank. At the close of business each day, Banks would transfer any amount in excess of 20% of the total of the amounts deposited with them to their account at the Central Bank, or call back from their account any amount below 20%. This would ensure that, in the event of a Bank failure, 80% of the Bank’s customers’ money was securely held in the Central Bank and could be promptly returned to them.

A state-operated Compensation Fund funded by compulsory contributions from all licensed Banks would, in the event of a Bank failure, make good the difference between the 80% funds held by the Central Bank and failed bank’s customer account balances.


Finance Houses would operate the deposit-and-loan and mortgage function currently operated by banks.
  • Finance Houses would be licensed to operate “time deposits accounts” as banks do now, i.e. the guaranteed return of a deposit by a specific date and the guaranteed payment of specified interest amounts
  • Finance Houses would be licensed to provide loans to individuals and businesses, and to charge interest. They would be prohibited from investing in the financial markets (such as derivatives, securitised mortgages, hedge funds, etc). They would be authorised to issue credit cards
  • For each Finance House, the maximum permitted total of loans would be geared to the total of their customers’ deposits. The maximum “loan-to-deposit ratio” would be limited to 5 times. That is, the total amount loaned out must not exceed 5 times the total amount deposited -- a “Fractional Reserve of 20%”
  • Where a loan is secured by property (a mortgage), or an asset (a car etc) or securities (equity, shares etc), the amount of the loan would be limited to a maximum of 80% of a realistic current selling value of the property, asset or security -- a “loan-to-value” of 80%
  • The amount of the interest payments on loans/mortgages would be “fixed” not variable, i.e. could not be increased during the lifetime of the loan
To curb Finance Houses from making imprudent and/or excessive loans, the following rules would be applied:
  • Pre-Loan Vetting. In setting up the loan and interest arrangement, the Finance House making the loan (both secured and unsecured, including credit cards) would be obligated to investigate in depth the current financial and other circumstances of the borrower to ensure that the repayment/interest terms are not unreasonable and are likely to be met. Official detailed “loan vetting guidelines” would be laid down with which the terms of loans had to comply. For vetting purposes the income amount would be actual, would exclude anticipated income
  • Loan Defaults and Recovery. Should the borrower default on the interest or repayment terms of the loan, the lender (the Finance House) would, as now, have right of redress through the courts. The lender would produce to the court the result of the vetting investigations it made prior to the loan. The court would find for the lender only if at the time of the loan the “not unreasonable”, the “loan vetting guidelines”, and for secured loans, the “loan-to-value” requirements had been met.
A state-operated Compensation Fund funded by compulsory contributions from all Finance Houses would, in the event of a Finance House failure, pay depositors up to the first £50,000 of their deposits.


If these banking rules were to be adopted, and when the World economy had steadied, what would be the likely outcome?

I anticipate that the overall standards of living and prosperity would not for several years return to the standards of 2007/8, which, as we now know were unsustainable. I anticipate that the economy would gradually return to the levels of the 1970s.


Other Financial papers in this series:

Recession I, Recession II, Recession III, Money Supply, Prices Wages & Inflation.

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