Why Basel III Will Fail and Isn’t Necessary Anyway

Published December 9, 2013

I recently “attended” an online webinar about Basel III’s proposed new liquidity requirements for banks. My goal in attending the webinar was to get a general idea of how difficult it would be for banks to understand the new regulations and comply with them. Plus, I wanted to assess the likely impact Basel III would have on bank operational costs and earnings.

Let’s cut right to the chase. These regulations are extremely complicated, to my mind almost incomprehensibly so. The narrated presentation of 45 very busy slides contained many caveats that certain provisions were unclear and/or still unresolved and were awaiting industry comments before final publication.

This webinar focused not on capital requirements, which were addressed at Basel I in 1988 and again at Basel II in 2004, but on liquidity requirements. Whereas bank capital is viewed as the ultimate guarantee of final payment of a bank’s liabilities, should its assets deteriorate, liquidity addresses the ability of a bank to quickly meet the demands of depositors for immediate redemption of their deposits.

What if there is an old-fashioned run on the bank and everyone wants his money right now? Can the bank honor its obligations…not tomorrow, or next week, or next month…but today? Basel III attempts to create a framework for banks to evaluate the quick liquidity of their short-term assets in relation to their short-term liabilities and set minimum liquidity ratios. When viewed in this context, an Austrian school economist immediately sees that Basel III is trying to compensate for the inevitable weakness of fractional reserve banking and the mixing of deposit banking with loan banking.

Money From Nothing

Fractional reserve banking allows banks to create money out of thin air through the lending process. When a bank obtains new reserves, for example from a new deposit, its reserve account at the Fed is credited for the full amount of the deposit.  However, under fractional reserve banking, the bank need maintain only a fraction of the deposit as reserves at the Fed.

Let us assume that the reserve ratio is 10 percent and the bank receives a new deposit of $10,00. The bank need keep only $1,000 as reserves against this $10,000 deposit. Although the bank of first deposit can safely lend only $9,000 of this new $10,000 deposit, the banking system as a whole can lend out $100,000, the reciprocal of the reserve ratio multiplied against the new reserve (1 / 10% reserve rate x $10,000 in new reserves = $100,000 total increase in fiat money).

Today’s “effective” reserve ratio is not 10 percent but just over 1 percent!  (Required reserves of $120 billion support $10.819 trillion of M2, the broadest measure of money.) Although before 2008 excess reserves in the banking system were minimal–seldom more than $2 billion dollars–as a result of the Fed’s quantitative easing programs the banking system currently holds $2.214 trillion in excess reserves. These excess reserves represent a potentially massive increase in the money supply, for as banks seek to maximize their profits via increased lending, they turn excess reserves into required reserves. This process may take a while, but there is no reason for the banking system to keep excess reserves.

Collapsing Money Pyramid

This pyramiding of new money on top of a small ratio of reserves causes disequilibrium in the time structure of production. The lower interest rate required to increase lending makes previously unsound investments appear to be sound.  Most of these are long-term investments for which the cost of money is a major factor. Since these long-term investments are not funded by a real increase in saving, there are no real resources freed for their completion. Eventually they will be liquidated. At that point the entire pyramid of new money collapses upon the banks in the form of loan losses. The banks now have “illiquid” assets with which to honor their deposit liabilities.

Notice that Basel III does not address this core problem. Capital has been destroyed by fiat money creation by sending it to stages of the structure of production that will never become profitable. This capital, on the banks’ books in the form of long-term bank loans, cannot be used to meet Basel III’s onerous liquidity rules because it no longer exists. Basel III regulations attack the symptom and not the cause of the disease–fiat money expansion. However, we can be assured that the politicians and the bureaucrats will host Basel IV and give it a good try!

Melding of Banking Styles

The only protection against money pyramids and their subsequent collapse is sound money, money backed 100 percent by reserves. This requirement would apply to bank notes, token coins, and bank book entry (checking) deposits. What we today call banking is a mixture of the melding of deposit banking and loan/investment banking.

Murray N. Rothbard described such a system decades ago in The Mystery of Banking. Deposit banking is the safekeeping of reserves and the production of efficient money transfer systems–checks, automated clearinghouse payments, paper notes, token coins, etc. None of these systems are money per se; they are fiduciary media, representing reserves held in safekeeping at the bank. The deposit side of the bank maintains 100 percent reserves against its notes and checking accounts. Deposit customers pay fees for safekeeping and money transfer services.  Real reserves cannot be destroyed, so real money cannot be destroyed. Thusly, real money cannot cause money pyramids which must collapse.

Under a sound money regime, the only liquidity regulation required is that the bank always maintain 100 percent reserves to back its fiduciary media. This is the job of an audit firm, not the job of a sophisticated bank consulting company.

For those banking customers who desire to employ their excess funds to earn an interest return, the loan/investment side of the bank serves as an intermediary; i.e., the depositor lends his excess funds to the banker who re-lends it at a high enough interest rate to pay for the cost of his services, the interest cost to the depositor, and a provision for possible loan losses. The bank’s deposit customer, who now is an investor in the bank, has no guarantee of the return of his funds aside from the size of the banker’s capital account and his reputation for making good loans.

The loan banker need practice simple asset/liability management, ensuring that his loans mature according to the same schedule as his deposits. The loan bank’s customers cannot withdraw their money before the end of the agreed upon term, unless the banker offers to do so at a substantial penalty to the depositor.

No Change in Supply

The important point is that when money is transferred from the deposit bank account to the loan bank account and subsequently to the loan customer, no new money has been created. The supply of money has remained the same throughout; the only thing that changed is who has temporary ownership of it. There is no need for Basel III. There is no need for special bank regulations and, thusly, no need for regulators. Banking becomes simply another business that is subject to normal, everyday commercial law.

If auditors find that the deposit banker has failed to maintain 100 percent reserves, the banker is subject to prosecution for criminal fraud and the confiscation of his personal assets to honor his deposit obligations. There can be no guarantee of the full return of the depositor’s money from the loan side of the bank, just as no one can guarantee that a bond or stock will retain its value.

Sound Rothbardian banking eliminates monetary inflation and the boom/bust business cycle along with the imbedded expense to pay for a great deal of unneeded regulatory compliance. Loan interest rates would fall as a result of falling bank operating expenses and loan losses. Sound money would reduce the inflationary premium currently built into bank loans to compensate them for being repaid in debased money. Bankers could concentrate on their core business of finding and nurturing good borrowing customers, rather than satisfying the needs of regulators who are always fighting the last war.