Why you cannot regulate systemic financial risk

Tuesday, Mar 08 2011 by
Why you cannot regulate systemic financial risk

Governments of countries affected by the financial crisis are preoccupied with designing a set of regulations that would prevent the future banking crisis (called liquidity shortage or credit crunch) from happening. The actions are taken on the local level, introducing new regulations, and international level, e.g. Basel III. At the same time nothing is done to break up banks so they are not "too big to fail" or to separate investment banking from high street banking that would prevent using depositors cash for, often very risky, financial speculation.

But is it possible to regulate financial risks? To get to the bottom of it, it is necessary to understand what the major factor of liquidity shortage risk is. Ever since the full reserve banking was abandoned, i.e. the situation when banks were acting as safe storage business and depositors had to pay to keep their money there, when bankers realised some hundreds years ago that at any one time they only get a withdrawal call on a small proportion of the deposits held, banks started circulating money. Circulation is in fact money multiplication, i.e. for every £100 paid in as deposits banks lend out a portion of it. Typically it was between £80 - £90. This made the banking system work as a statistical machine whereby for every £100 liability, the bank held only £10 - £20 cash.

The risks of running a banking system in such a way is rather obvious. The first one is psychological: if depositors demanded a large proportion of their deposits, for whatever reason, a bank would not have money to satisfy them. This is called a bank run. Banks were insured for such a contingency in two ways.

The first one was banks lending to one another. In case one bank was short of liquidity another bank was lending it to satisfy the demand. As the interbank interest rate of lending was lower than what banks were offering their customers, all banks were still making money, it was a profit sharing scheme, and the whole system worked like an integrated statistical machine.

The second way of insuring against liquidity shortage was keeping the actual liquidity reserves at the appropriate level. For example, at every one time, for every £100 possible immediate withdrawal call, a bank has say £15. And this is a hard one. Banks create money out of nothing: they…

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About Greg Pytel

Greg Pytel

Greg Pytel is a quantitative risk expert & international business development consultant. He has extensive international experience advising governments and companies within the area of hydrocarbons exploration and international telecommunication licensing. He started his career with Shell Exploration in 1990 and continued with Petroleum Geo-Services in Norway. From 2000 he has been involved with private consulting practice that also covered fraud risk assessment and investigations. more »

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