Bank Capital: An Effective Strategy?

If you ask any group of American Tea Party protestors why they are so angry with their government, you’ll likely receive an earful of complaints in return. Most commonly, though, they’ll tell you that they fear for their liberty.

Liberty? What do they mean by liberty? Well, unlike freedom — an exceedingly broad concept that embraces all of speech, religion, want, and fear — liberty has a far narrower definition. In fact, it refers to a single vital human freedom: the state of being free from excessive government oversight and interference.

At first glance, last week’s announcement of a new set of global banking regulations — established by a worldwide group of government regulators named after the Swiss city of Basel — hardly seems to represent a return to the principles of liberty. Nevertheless, over the long term, its goal is to reduce the level of government interference in the banking sector.

A Capital Emphasis

The Basel group itself is a global governmental entity, the very type of organization that is often criticized by Tea Party protestors. Its official name is the Basel Committee on Banking Supervision; its members are drawn from the national government banks of over two dozen countries. Their member agreements, once ratified by their host nations, become international treaties and thus contribute to our system of global government and law.

Two years ago, when a significant number of “too big to fail” financial institutions careened towards bankruptcy and threatened to pull down the world’s economic system, many of our national government banks reacted by bailing out the failing firms. Since that time, the Basel Committee has debated various approaches for ensuring that such bailouts will never be required again.

In a sense, the Basel group has been searching for a way to impose new government regulations today — which themselves can be construed as impositions on liberty – in order to ensure that massive government interventions in the economy will not be required tomorrow. Their solution, as they announced last week, is based on a strategy of capital.

To put it simply, over the next decade, the amount of capital that banks will need to keep in reserve to cover their own losses will increase from 2% to 7%. Furthermore, they will need to maintain these reserves in common equity and not in exotic securities, i.e. in plain, ordinary funds that can be easily deployed to cover unanticipated shortfalls.

Will It Help? Or Will It Hurt?

There is indeed a certain amount of logic that is embedded in a strategy of greater capital requirements; after all, the more funds available within banks to cover their own losses, the less funds that must be contributed by governments to bail out the failing firms. And yet economists and financial experts continue to argue over whether this strategy will actually help or hurt the economy.

Some critics complain that the new regulations will hurt economic prosperity because banks will need to sock away more capital instead of lending it to businesses to help them grow. They also complain that the regulations do nothing to break up the mammoth banks that were deemed “too big to fail,” thereby leaving these goliaths in place to dominate the global financial markets.

In addition, such critics note, an increase in capital reserves from 2% to 7% may simply reduce the size of governmental bail-outs of the global financial system from 98% to 93% of the world’s banking liabilities. Although any reduction in the cost of bail-outs is undeniably beneficial, that’s still far too high a percentage to make any one feel comfortable!

Learning From History

Looking back through history, many creative approaches have been employed over the years to prevent bank failures, though few of them have succeeded in being both popular and effective. In 1907, for instance, the legendary banker J.P. Morgan single-handedly coordinated the activities of the chief executives of the nation’s largest financial institutions as they developed and executed a strategy for bailing themselves out without government intervention.

Ironically, although Morgan succeeded in saving the banking system in 1907, Americans were so unnerved by the concentration of economic power in the hands of a single man that they agreed to the establishment of a government Federal Reserve Bank in 1912. Despite concerns that centralized control over the banking system represents a threat to American liberty, the Fed has been overseeing the nation’s financial system ever since.

It is indeed difficult to argue against the proposition that greater capital reserves can serve as a larger cushion against future bank failures. Nevertheless, history informs us that this action alone may not be sufficient to protect us against calamitous market crashes.

So what can a citizen do to protect himself against such future events? Stash a little more cash under the mattress, perhaps, and hope that banking regulators will continue their search for effective (and yet not overly intrusive) oversight mechanisms!